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Committee on Banking Sector Reforms (Narasimham Committee II) - Action taken onthe recommendations

Recommendation Action TakenMeasures to strengthen the banking system:Capital Adequacy:

1. The Committee suggests that pending theemergence of markets in India where marketrisks can be covered, it would be desirablethat capital adequacy requirements take intoaccount market risks in addition to the creditrisks. (Chapter III Para 3.10)

Banks are now required to assign capital formarket risk. A risk weight of 2.5% for marketrisk has been introduced on investments inGovt. and other approved securities witheffect from the year ending 31st March, 2000.For investments in securities outside SLR, arisk weight of 2.5% for market risk has beenintroduced with effect from the year ending31st March, 2001.

(Circulars DBOD.No.BP.BC.103 /21.01.002/98 dated 31.10.98 and 121/21.04.124/99-2000 dated 3.11.99).

2. In the next three years, the entireportfolio of Government securities should bemarked to market and this schedule ofadjustment should be announced at theearliest. It would be appropriate that thereshould be a 5% weight for market risk forGovt. and approved securities. (Chapter IIIpara 3.11)

The percentage of banks’ portfolio of Govt.and approved securities which is required tobe marked to market has progressively beenincreased. For the year ending 31st March,2000, banks were required to mark to market75% of their investments. In order to align theIndian accounting standards with theinternational best practices and taking intoconsideration the evolving internationaldevelopments, the norms for classificationand valuation of investments have beenmodified with effect from September 30,2000. The entire investment portfolio ofbanks is required to be classified under threecategories, viz., Held to Maturity, Availablefor Sale and Held for Trading. While thesecurities ‘Held for Trading’ and ‘Availablefor Sale’ should be marked to marketperiodically, the securities ‘Held to Maturity’,which should not exceed 25% of totalinvestments are carried at acquisition costunless it is more than the face value, in whichcase, the premium should be amortised over aperiod of time. (Circular DBOD. NoBP.BC.32/21.04.048/2000-2001 dated16.10.2000. )

3. The risk weight for a Governmentguaranteed advance should be the same asfor other advances. To ensure that banks donot suddenly face difficulties in meeting the

In cases of Govt. guaranteed advances,where the guarantee has been invoked and theconcerned State Govt. has remained in defaultas on March 31, 2000, a risk weight of 20%

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capital adequacy requirement, the newprescription on risk weight for Governmentguaranteed advances should be madeprospective from the time the newprescription is put in place. (Chapter III para3.12)

on such advances, has been introduced. StateGovts. who continue to be in default inrespect of such invoked guarantees even afterMarch 31, 2001, a risk weight of 100% isbeing assigned.(Circular DBOD.NO.BP.BC.103/21.01.002/98 dated 31.10.98)

4. There is an additional capital requirementof 5% of the foreign exchange open positionlimit. Such risks should be integrated intothe calculation of risk weighted assets. TheCommittee recommends that the foreignexchange open position limits should carrya 100% risk weight. (Chapter III para 3.13)

Risk weight of 100% has been introduced forforeign exchange open position limits witheffect from March 31, 1999. (CircularDBOD.No.BP. BC.103/21.01.002/98dt.31.10.98)

5. The Committee believes that it would beappropriate to go beyond the earlier normsand set new and higher norms for capitaladequacy. The Committee accordinglyrecommends that the minimum capital torisk assets ratio be increased to 10% from itspresent level of 8%. It would be appropriateto phase the increase as was done on theprevious occasion. Accordingly, theCommittee recommends that an intermediateminimum target of 9% be achieved by theyear 2000 and the ratio of 10% by 2002.The RBI should also have the authority toraise this further in respect of individualbanks if in its judgement the situation withrespect to their risk profile warrants such anincrease. The issue of individual banks'shortfalls in the CRAR needs to beaddressed in much the same way that thediscipline of reserve requirements is nowapplied, viz., of uniformity across weak andstrong banks. (Chapter III, para 3.15 – 3.16)

The minimum capital to risk asset ratio(CRAR) for banks has been enhanced to 9%with effect from the year ending March31,2000.(Circular DBOD.No.BP.BC.103/21.01.002/98dated 31.10.98).

6. In respect of PSBs, the additional capitalrequirement will have to come from eitherthe Govt. or the market. With the manydemands on the budget and the continuingimperative need for fiscal consolidation,subscription to bank capital funds cannot beregarded as a priority claim on budgetaryresources. Those banks which are in aposition to access the capital market at homeor abroad should, therefore, be encouragedto do so. (Chapter III, para 3.17)

Banks are permitted to access the capitalmarket. Till today, 12 banks have alreadyaccessed capital market.

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Asset quality, NPAs and Directed Credit:7. The Committee recommends that an assetbe classified as doubtful if it is in thesubstandard category for 18 months in thefirst instance and eventually for 12 monthsand loss if it has been so identified but notwritten off. These norms, which should beregarded as the minimum, may be broughtinto force in a phased manner.(Chapter III,para 3.18)

Banks have been advised that an asset will beclassified as ‘doubtful’ if it has remained inthe substandard category for 18 monthsinstead of 24 months as at present, by March31, 2001. Banks have been permitted toachieve these norms for additionalprovisioning in phases, as under :As on 31.3.2001Provisioning of not less than 50% on theassets which have become doubtful onaccount of the new norm.As on 31.3.2002Balance of the provisions not made during theprevious year, in addition to the provisionsneeded as on 31.3.2002.

(Circular DBOD.No.BP.BC.103/21.01.002/98dt.31.10.98)

Introduction of the norm of 90 days forincome recognition in a phased manner.

In the Monetary and Credit Policy announcedin April 2001, the banks have been advised tochalk out an appropriate tranisition path forsmoothly moving over to 90 days norm. As afacilitating measure, banks should move overto charging of interest at monthly rests byApril 1, 2002. Banks should commencemaking additional provisions for such loans ,starting from the year ending March 31, 2002,which would strengthen their balance sheetsand ensure smooth transition to the 90 daysnorm by March 31, 2004.

8. The Committee has noted that NPAfigures do not include advances covered byGovernment guarantees which have turnedsticky and which in the absence of suchguarantees would have been classified asNPAs. The Committee is of the view that forthe purposes of evaluating the quality ofasset portfolio such advances should betreated as NPAs. If , however, for reason ofthe sovereign guarantee argument suchadvances are excluded from computation, theCommittee would recommend thatGovernment guaranteed advances whichotherwise would have been classified asNPAs should be separately shown as anaspect of fuller disclosure and greatertransparency of operations. (Chapter III,para 3.21)

Prudential norms in respect of advancesguaranteed by State Governments whereguarantee has been invoked and has remainedin default for more than two quarters has beenintroduced in respect of advances sanctionedagainst State Government guarantee witheffect from April 1, 2000. Banks have beenadvised to make provisions for advancesguaranteed by State Governments whichstood invoked as on March 31, 2000, inphases, during the financial years endingMarch 31, 2000 to March 31, 2003 with aminimum of 25% each year. ( Circular DBOD. No.BP.BC.103/21.01.002/98 dt.31.10.98).

9. Banks and financial institutions should The RBI has reiterated that banks and

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avoid the practice of "evergreening" bymaking fresh advances to their troubledconstituents only with a view to settlinginterest dues and avoiding classification ofthe loans in question as NPAs. TheCommittee notes that the regulatory andsupervisory authorities are paying particularattention to such breaches in the adherenceto the spirit of the NPA definitions and aretaking appropriate corrective action. At thesame time, it is necessary to resist thesuggestions made from time to time for arelaxation of the definition of NPAs and thenorms in this regard (Chapter III, para 3.22)

financial institutions should adhere to theprudential norms on asset classification,provisioning, etc. and avoid the practice of“evergreening”.(Cir.DBOD. No.BP. BC.103/21.01.002/98dt.31.10.98)

10. The Committee believes that the objectiveshould be to reduce the average level of netNPAs for all banks to below 5% by the year2000 and to 3% by 2002. For those bankswith an international presence the minimumobjective should be to reduce gross NPAs to5% and 3% by the year 2000 and 2002,respectively, and net NPAs to 3% and 0% bythese dates. These targets cannot beachieved in the absence of measures to tacklethe problem of backlog of NPAs on a onetime basis and the implementation of strictprudential norms and management efficiencyto prevent the recurrence of this problem.(Chapter III, para 3.26)

This is the long-term objective which RBIwants to pursue. Towards this direction, anumber of measures have been taken to arrestthe growth of NPAs: banks have been advisedto tone up their credit risk managementsystems; put in place a loan reviewmechanism to ensure that advances,particularly large advances are monitored onan on-going basis so that signals ofweaknesses are detected and correctiveaction taken early ; enhance credit appraisalskills of their staff, etc. In order to ensurerecovery of the stock of NPAs, guidelines forone-time settlement have been issued inJuly,2000.

11. The Committee is of the firm view thatin any effort at financial restructuring in theform of hiving off the NPA portfolio from thebooks of the banks or measures to mitigatethe impact of a high level of NPAs must gohand in hand with operationalrestructuring. Cleaning up the balance sheetsof banks would thus make sence only ifsimultaneously steps were taken to preventor limit the re-emergence of new NPAs whichcould only come about through a strictapplication of prudential norms andmanagerial improvement.(Chapter III, para3.27)

Banks have been advised to take effectivesteps for reduction of NPAs and also put inplace risk management systems and practicesto prevent re-emergence of fresh NPAs. (Cir.DBOD. No. BP. BC. 103 /21.01.002/98 dated31.10.1998)

12. For banks with a high NPA portfolio,the Committee suggests consideration of twoalternative approaches to the problem as analternative to the ARF proposal made by the

The proposal to set up an AssetReconstruction Company (ARC) on a pilotbasis to take over the NPAs of the three weakpublic sector banks, has been announced in

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earlier CFS. In the first approach, all loanassets in the doubtful and loss categories -which in any case represent bulk of thehard core NPAs in most banks should beidentified and their realisable valuedetermined. These assets could betransferred to an Asset ReconstructionCompany (ARC) which would issue to thebanks NPA Swap Bonds representing therealisable value of the assets transferred,provided the stamp duties are not excessive.The ARC could be set up by one bank or aset of banks or even in the private sector. Incase the banks themselves decide to set up anARC, it would need to be ensured that thestaff required by the ARC is made availableto it by the banks concerned either ontransfer or on deputation basis, so that staffwith institutional memory on NPAs isavailable to ARC and there is also somerationalisation of staff in the banks whoseassets are sought to be transferred to theARC. Funding of such an ARC could befacilitated by treating it on par with venturecapital for purpose of tax incentives. Someother banks may be willing to fund suchassets in effect by securitising them. Thisapproach would be worthwhile and workableif stamp duty rates are minimal and taxincentives are provided to thebanks.(Chapter III, para 3.28)

the Union Budget for 1999 – 2000. Themodalities for setting up the ARC are beingexamined.

13. An alternative approach could be toenable the banks in difficulty to issue bondswhich could form part of Tier II capital. Thiswill help the banks to bolster capitaladequacy which has been eroded because ofthe provisioning requirements for NPAs. Asthe banks in difficulty may find it difficult toattract subscribers to bonds. Governmentwill need to guarantee these instrumentswhich would then make them eligible for SLRinvestments by banks and approveinstruments by LIC, GIC and ProvidentFunds (Chapter III, para 3.29 )

Banks are permitted to issue bonds foraugmenting their Tier II capital. Guarantee ofthe Govt. for these bonds is not considerednecessary.

14. Directed credit has a proportionatelyhigher share in NPA portfolio of banks andhas been one of the factors in erosion in thequality of bank assets. There is continuingneed for banks to extend credit to agriculture

The loans to agricultural and SSI sectors arenow generally being granted on commercialconsiderations and on the basis ofcreditworthiness of the borrower. Further, theconcessionality on interest rates for advances

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and small scale sector which are importantsegments of the national economy, oncommercial considerations and on the basisof creditworthiness. In this process, there isscope for correcting the distortions arisingout of directed credit and its impact onbanks’ assets quality. (Chapter III, para3.31)

has been done away with, except foradvances under the DRI Scheme. Whileadvances upto Rs.2 lakh should carry interestrate not exceeding PLR, interest rates onadvances of over Rs.2 lakh have been freed.

15. The Committee has noted the reasonswhy the Government could not accept therecommendation for reducing the scope ofdirected credit under priority sector from40% to 10%. The Committee recognises thatthe small and marginal farmers and the tinysector of industry and small businesses haveproblems with regard to obtaining credit andsome earmarking may be necessary for thissector. Under the present dispensation,within the priority sector 10% of net bankcredit is earmarked for lending to weakersections. A major portion of this lending ison account of Government sponsoredpoverty alleviation and employmentgeneration schemes. The Committeerecommends that given the special needs ofthis sector, the current practice maycontinue. The Branch Managers of banksshould, however, be fully responsible for theidentification of beneficiaries under theGovernment sponsored credit linkedschemes. The Committee proposes that giventhe importance and needs of employmentoriented sectors like food processing andrelated service activities in agriculture,fisheries, poultry and dairying, these sectorsshould also be covered under the scope ofpriority sector lending. The Committeerecommends that the interest subsidy elementin credit for the priority sector should betotally eliminated and even interest rates onloans under Rs.2 lakh should be deregulatedfor scheduled commercial banks as has beendone in the case of Regional Rural Banksand co-operative credit institutions. TheCommittee believes that it is the timely andadequate availability of credit rather than itscost which is material for the intendedbeneficiaries. The reduction of the pre-empted portion of banks' resources through

As per the present stipulation, banks arerequired to lend 10% of net bank credit(NBC) for weaker sections which includes allsmall and marginal farmers, all IRDP andDRI borrowers, borrowers under SUME etc.The Committee has recommended that thepresent stipulation may continue.As recommended by the Committee, someactivities like food processing, related serviceactivities in agriculture, fisheries, poultry,dairying have been brought under prioritysector. (circular RPCD. NO. Plan. BC.60/04.09.01/ 98-99 dt.28-1-99). Under the existing dispensation, Units insectors like food processing, etc., satisfyingeither the definition of SSI [ the ceiling ofinvestment in plant and machinery (originalcost) for a unit being classified under thiscategory has since been enhanced to Rs. 3crore from Rs.60 lakhs / Rs.75 laks forancillaries and export oriented units] or smallbusiness are already covered under prioritysector. No further changes are considerednecessary, as larger units need not be givenany advantage by enlarging the scope ofdefinition of priority sector advances.As a first step towards deregulation of interestrates on credit limits up to R.2 lakh andeliminating interest subsidy element in creditfor priority sector, in the Monetary andCredit Policy announced in April, 1998, ithas been stipulated that interest rates on loansup to Rs.2 lakh should not exceed PLR asagainst the earlier stipulation of ‘notexceeding 13.5%’, for credit limits ofRs.25,000--Rs.2 lakh and 12% for creditlimit up to Rs.25,000. Banks are free todecide their PLR subject to their obtaining theprior approval of their Boards therefor. Asthe PLR differs from bank to bank, dependingon their cost of funds and competitive

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the SLR and CRR would, in any case,enlarge the ability of banks to dispense creditto these sectors. (Chapter III, para 3.32)

strategies, the measure is a step towardsderegulation of interest rates. Thus therecommendation of the Committee has beenimplemented in spirit. It may be stated thatexcept for loans under DRI there is nosubsidisation of interest.

(Cir. MPD.BC.175/07.01.279/97-98 dated29.4.98)

Prudential Norms and DisclosureRequirements:

16. With regard to income recognition, inIndia, income stops accruing when interestor instalment of principal is not paid within180 days. The Committee believes that weshould move towards international practicesin this regard and recommends theintroduction of the norm of 90 days in aphased manner by the year 2002.(ChapterIII, para 3.35)

The recommendation of the Committee thatwe should move towards internationalpractices in regard to income recognition isaccepted in principle. However, tightening ofthe prudential norms should be made keepingin view the existing legal framework,production and payment cycles, businesspractices, the predominant share ofagriculture in the country’s economy, etc. Theproduction and repayment cycles in theindustry in the country generally involve aperiod of not less than from 4 to 6 months. Alarge number of SSIs also have difficulties intimely realization of their bills drawn on thesuppliers. These have to be taken into accountwhile contemplating any change in the norm. Implementation of the recommendationwould have serious implications on the assetportfolio of banks and even good qualityborrowers and find it difficult to comply withthe norms recommended. There have beenrepresentations from banks and financialinstitutions seeking relaxations in the aboveinstructions by increasing the period to 3-4quarters. Keeping in view the currentindustrial scenario, implementation of therecommendation would have seriousimplications even to healthy borrowers.Furthermore, interest on advances iscalculated by banks at quarterly rests.Keeping in view the large number and volumeof accounts, if we have to implement therecommendation, a few preconditions shouldbe met : -

[a] Banks should introduce calculation ofinterest at monthly rests;[b] There should be 100% computerization ofbanks’ operations. Unless 100%

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computerization is made, it may not befeasible to implement the recommendation ;[c] It is also necessary to tone up the legalmachinery for speedy disposal of thecollateral taken as security for the advance.However, considering the need to bring ournorms in line with the best internationalpractices, the recommendations made by theCommittee would be our long term objective.As the level of gross NPAs of banks comedown because of better managementpractices, the recommendation to introducethe norm of 90 days will be examined.

17. At present, there is no requirement inIndia for a general provision on standardassets. In the Committee’s view a generalprovision, say, of 1% would be appropriateand RBI should consider its introduction ina phased manner. (Chapter III, para 3.36)

To start with, a general provision on standardassets of a minimum of 0.25% from the yearended March 31, 2000 introduced. (Cir.DBOD. No.BP.BC.103/21.01.002/98dt.31.10.98)

18. The Committee believes that in the caseof future loans, the income recognition andasset classification and provisioning normsshould apply even to Government guaranteedadvances in the same manner as for anyother advance. For existing Governmentguaranteed advances, RBI, Government andbanks may work out a mechanism for aphased rectification of the irregularities inthese accounts. (Chapter III, para 3.37)

Please see comments in respect of item No.8above.

19. There is a need for disclosure, in aphased manner, of the maturity pattern ofassets and liabilities, foreign currencyassets and liabilities, movements in provisionaccount and NPAs. The RBI should directbanks to publish, in addition to financialstatements of independent entities, aconsolidated balance sheet to reveal thestrength of the group. Full disclosure wouldalso be required of connected lending andlending to sensitive sectors. Furthermore, itshould also ask banks to disclose loans givento related companies in the bank's balancesheets. Full disclosure of information shouldnot be only a regulatory requirement. Itwould be necessary to enable a bank’screditors, investors and rating agencies toget a true picture of its functioning – animportant requirement in a market driven

Banks have been advised to disclose thefollowing information, in addition to theexisting disclosures, in the ‘Notes onAccounts’ to the balance sheet from theaccounting year ended March 31, 2000.

i. Maturity pattern of loans andadvances,

ii. Maturity pattern of investmentsecurities,

iii. Foreign currency assets andliabilities

iv. Movement in NPAs,v. Maturity pattern of depositsvi. Maturity pattern of borrowingsvii. Lending to sensitive sectors as

defined from time to time

(Cir.DBOD.No.BP.BC.9/21.04.018/99

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financial sector. (Chapter III, para 3.38) dt.10.2.99)

20. Banks should also pay greater attentionto asset liability management to avoidmismatches and to cover, among others,liquidity and interest rate risks. (Chapter III,para 3.41).

Detailed guidelines issued to banks on asset –liability management. Implementation ofthese guidelines would enable banks to avoidliquidity mismatches as also to cover, amongothers, liquidity and interest rate risks.(Circular. DBOD.No.BP.BC.8/21.04.098/99dated 10th February, 1999).

21. Banks should be encouraged to adoptstatistical risk management techniques likeValue-at-Risk in respect of balance sheetitems which are susceptible to market pricefluctuations, forex rate volatility and interestrate changes. While the Reserve Bank mayinitially, prescribe certain normative modelsfor market risk management, the ultimateobjective should be that of banks building uptheir own models and RBI backtesting themfor their validity on a periodicalbasis.(Chapter III, para 3.41 – 3.42)

Comprehensive guidelines have been issuedto enable banks to put in place appropriaterisk management systems. Banks have alsobeen advised to adopt statistical riskmanagement techniques like Value-at-Risk (which is a statistical method of assessing thepotential maximum loss from a credit orinvestment exposure, over a definite holdingperiod at a given confidence level) or othermodels appropriate to their level of businessoperation. (Circular. DBOD. No. BP.BC98/21.04.103/99 dated 7.10.99)

Systems and Methods in Banks :

22. Banks should bring out revisedOperational Manuals and update themregularly, keeping in view the emergingneeds and ensure adherence to theinstructions so that these operations areconducted in the best interest of a bank andwith a view to promoting good customerservice. These should form the basicobjective of internal control systems, themajor components of which are : (I) InternalInspection and Audit, including concurrentaudit, (2) Submission of Control Returns bybranches/controlling offices to higher leveloffices (3) Visits by controlling officials tothe field level offices (4) Risk managementsystems (5) Simplification of documentation,procedure and of inter office communicationchannels.(Chapter IV, para 4.3)

Banks have been advised to bring out revisedOperative Manuals and update themregularly. Banks have confirmed havingbrought out revised Manuals. (Circular.DBOD. No.BP.BC.29/21.01.023/98-99dt.16.4.99 )

23. An area requiring close scrutiny in thecoming years would be computer audit, inview of large scale usage and reliance oninformation technology (Chapter IV, para4.7)

Banks have been advised to set up EDP AuditCell, as part of their Inspection Department. (circular DBS. No. CO PP.BC.55/11.01.005/98-99 dated 19.6.99).

24. There is enough international experience RBI had in 1992 emphasised to banks the

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to show the dangers to an institution arisingout of inadequate reporting to and checkingby the back offices of trading transactionsand positions taken. Banks should payspecial attention to this aspect (Chapter IV,para 4.8).

importance of an effective managementreporting system, segregation of the tradingand back office functions, etc. The efficacyof the systems put in place by banks is beingconstantly reviewed by the RBI throughperiodical inspections.( Circular DBOD. No. FSC. BC. 143A/24.48.001/91-92 dt.20.6.92)

25. There is need to institute an independentloan review mechanism especially for largeborrowal accounts and systems to identifypotential NPAs. It would be desirable thatbanks evolve a filtering mechanism bystipulating in-house prudential limits beyondwhich exposures on single/group borrowersare taken keeping in view their risk profile asrevealed through credit rating and otherrelevant factors. Further, in-house limitscould be thought of to limit the concentrationof large exposures andindustry/sector/geographical exposureswithin the Board approved exposure limitsand proper overseeing of these by thesenior management/ boards. (Chapter IV,para 4.12 – 4.16)

Banks have been advised to put in place anindependent Loan Review Mechanism, asrecommended by the Committee. (Cir.DBOD.No.BP.BC.103/21.01.002/98 dated31.10.98).

26. The Committee feels that the presentpractice of RBI selection of statutoryauditors for banks with Board of Directorshaving no role in the appointment process,is not conducive to sound corporategovernance. We would recommend that theRBI may review the existing practice in thisregard. It may also reassess the role andfunction of the Standing Advisory Committeeon Bank Audit in the light of the setting up ofthe Audit Committee under the aegis of theBoard for Financial Supervision.(ChapterIV, para 4.19)

The recommendation was put up before theAudit Sub-Committee of the Board forFinancial Supervision which was of the viewthat the existing practice should continue.

27. The Committee notes that public sectorbanks and financial institutions have yet tointroduce a system of recruiting skilledmanpower from the open market. TheCommittee believes that this delay has hadan impact on the competency levels of publicsector banks in some areas and they haveconsequently lost some ground to foreignbanks and the newly set up private sectorbanks. The Committee urges that this aspect

The public sector banks have been permittedto recruit from the open market or by way ofcampus recruitment, skilled personnel in areaslike information technology, riskmanagement, treasury operations, etc.

As regards the recommendation in regard todiscontinuing the practice of recruitment ofofficers through Banking ServicesRecruitment Boards, Govt. may furnish

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be given urgent consideration and in casethere are any extant policy drivenimpediments to introducing this system,appropriate steps be taken by the authoritiestowards the needed deregulation. Bankshave to tone up their skills base by resorting,on an ongoing basis, to lateral induction ofexperienced and skilled personnel,particularly for quick entry into newactivity/areas. The Committee notes thatthere has been considerable decline in thescale of merit-based recruitment even at theentry level in many banks. The concept ofdirect recruitment itself has beenconsiderably diluted by many PSBsincluding the State Bank of India by countinginternal promotions to the trainee officers'cadre as direct recruitment. The Committeewould strongly urge the managements ofpublic sector banks to take steps to reversethis trend. The CFS had recommended thatthere was no need for continuing with theBanking Service Recruitment Boards insofaras recruitment of officers was concerned.This Committee, upon examination of theissue, reaffirms that recommendation. As forrecruitment in the clerical cadre, theCommittee recommends that a beginning bemade in this regard by permitting three orfour large. well-performing banks, includingState Bank of India, to set up their ownrecruitment machinery for recruiting clericalstaff. If the experience under this newarrangement proves satisfactory, it couldthen pave the way for eventually doing awaycompletely with the Banking ServiceRecruitment Boards.(Chapter IV, para 4.21 –4.23)

comments.

28. It seems apparent that there are varyinglevels of overmanning in public sector banks.The managements of individual banks mustinitiate steps to measure what adjustments inthe size of their work force is necessary forthe banks to remain efficient, competitive andviable. Surplus staff, where identified, wouldneed to be redeployed on new business andactivities, where necessary after suitableretraining. It is possible that even after thissome of the excess staff may not be suitablefor redeployment on grounds of aptitude and

While some of the public sector banks haveintroduced VRS after consultations withEmployees’ Unions, others are in the processof introducing such schemes.

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mobility. It will, therefore, be necessary tointroduce an appropriate VoluntaryRetirement Scheme with incentives. Themanagements of banks would need to initiatedialogue in this area with representatives oflabour. (Chapter IV, para 4.5 & 4.24).29. The Committee would urge themanagements of Indian banks to review thechanging training needs in individual bankskeeping in mind their own businessenvironment and to address these urgently.(Chapter IV, para 4.32)

Banks have been advised to review thetraining needs and give more focus toemerging areas like Credit Management,Treasury Management, Risk Management,Information Technology, etc.(Circular DBOD.No.BP.BC.103/21.01.002/98dated 31.10.1998).

30. Globally, banking and financial systemshave undergone fundamental changesbecause of the ongoing revolution ininformation and communications technology.Information technology and electronic fundstransfer systems have emerged as the twinpillars of modern banking development. Thisphenomenon has largely bypassed the Indianbanking system although most technologiesthat could be considered suitable for Indiahave been introduced in some diluted form.The Committee feels that requisite success inthis area has not been achieved because ofthe following reasons:

? Inadequate bank automation.? Not so strong commercially oriented

inter-bank platform.? Lack of a planned, standardised,

electronic payment systems backbone.? Inadequate telecom infrastructure.? Inadequate marketing effort.? Lack of clarity and certainty on legal

issues and? Lack of data warehousing network.

The Committee has tried to list out series ofimplementation steps for achieving rapidinduction of information technology in thebanking system. Further, information andcontrol systems need to be developed inseveral areas like

? Better tracking of spreads, costs andNPAs for higher profitability.

? Accurate and timely information forstrategic decisions to identify and

A Working Group was set up withrepresentation from public sector banks,technology experts, to operationalise andimplement the programme of computerisationfor banks within a definite time frame. All therecommendations of Group have beenaccepted for implementation.In pursuance of the recommendations of theWorking Group, the Indian FinancialNetwork(INFINET), a wide area Satellitebased network using VSAT technology hasbeen commissioned on 24th June, 1999 atIDRBT, Hyderabad which will connect bankbranches and RBI Offices in a phasedmanner.The development of the Payment SystemGeneric Architecture Model for both domesticand cross-border payments has beenundertaken. A consultant has been appointed to assist inthe implementation of the RTGS. Progress is also being made towardsdeveloping standards for newer paymentinstruments such as Smart Cards.

Three standing Committees to reviewsecurity policies, message formats, software,to examine legal issues on electronic bankingand to monitor progress of computerization ofbranches of banks handling Govt. transactionshave been formed. Public Sector Banks havebeen advised to report technology progress on20 short-listed action points.

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promote profitable products andcustomers.

? Risk and Asset-Liability management;and

? Efficient Treasury management.(Chapter IV, para 4.66 & 4.70)

Structural Issues :

31. The Committee has taken note of the twinphenomena of consolidation andconvergence which the financial system isnow experiencing globally. In India alsobanks and DFIs are moving closer to eachother in the scope of their activities. TheCommittee is of the view that with suchconvergence of activities between banks andDFIs, the DFIs should, over a period oftime, convert themselves to banks. Therewould then be only two forms ofintermediaries, viz. banking companies andnon-banking finance companies. If a DFIdoes not acquire a banking licence within astipulated time it would be categorised as anon-banking finance company. A DFI whichconverts to a bank can be given some time tophase in reserve requirements in respect ofits liabilities to bring it on par with therequirements relating to commercial banks.Similarly, as long as a system of directedcredit is in vogue a formula should beworked out to extend this to DFIs whichhave become banks (Chapter V, para 5.6) .

Based on the recommendations of the KhanWorking Group on Harmonisation of the Roleand Operations of banks and DFIs, RBI hadreleased a Discussion Paper in January,1999 for wider public debate. The feedbackon the discussion paper indicated that whileuniversal banking is desirable from the pointof view of efficiency of resource use, there isneed for caution in moving towards such asystem by banks and DFIs. Major areasrequiring attention are the status of financialsector reforms, the state of preparedness ofconcerned institutions, the evolution ofregulatory-regime and above all a viabletransition path for institutions which aredesirous of moving in the direction ofuniversal banking. The Monetary and CreditPolicy for the year 2000 –2001 proposed toadopt the following broad approach forconsidering proposals in this area :

a. The principle of “Universal Banking”is a desirable goal and some progresshas already been made by permittingbanks to diversify into investmentsand long-term financing and the DFIsto lend for working capital, etc.However, banks have certain specialcharacteristics and as such anydilution of RBI’s prudential andsupervisory norms for conduct ofbanking business would beinadvisable. Further, anyconglomerate, in which a bank ispresent, should be subject to aconsolidated approach to supervisionand regulation.

b. Any DFI, which wishes to do so,should have the option to transforminto bank (which it can exercise),

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provided the prudential norms asapplicable to banks are fullysatisfied. To this end, a DFI wouldneed to prepare a transition path inorder to fully comply with theregulatory requirement of a bank. TheDFI concerned may consult RBI forsuch transition arrangements. ReserveBank will consider such requests on acase by case basis.

(Circular MPD.BC.196/07.01.279/99-2000 dt. 27.4.2000)

32. Mergers between banks and betweenbanks and DFIs and NBFCs need to bebased on synergies and locational andbusiness specific complimentarities of theconcerned institutions and must obviouslymake sound commercial sense. Mergers ofpublic sector banks should emanate frommanagement of banks with Govt. as thecommon shareholder playing a supportiverole. Such mergers, however, can beworthwhile if they lead to rationalisation ofworkforce and branch network; otherwisethe mergers of public sector banks would tiedown the managements with operationalissues and distract attention from the realissue. It would be necessary to evolvepolicies aimed at "rightsizing" andredeployment of the surplus staff either byway of retraining them and giving themappropriate alternate employment or byintroducing a VRS with appropriateincentives. This would necessitate the co-operation and understanding of theemployees and towards this direction,managements should initiate discussionswith the representatives of staff and wouldneed to convince their employees about theintrinsic soundness of the idea, thecompetitive benefits that would accrue andthe scope and potential for employees' ownprofessional advancement in a largerinstitution. Mergers should not be seen as ameans of bailing out weak banks. Mergersbetween strong banks/FIs would make forgreater economic and commercial sense andwould be a case where the whole is greaterthan the sum of its parts and have a "force

The recommendation has been noted. A non-banking finance company has since beenpermitted to merge with a bank. Two banksin the private sector have also merged basedon synergies and business specificcomplementarities.

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multiplier effect".(Chapter V, para 5.13 –5.15)

33. A ‘weak bank’ should be one whoseaccumulated losses and net NPAs exceed itsnet worth or one whose operating profits lessits income on recapitalisation bonds isnegative for three consecutive years. A caseby case examination of the weak banksshould be undertaken to identify those whichare potentially revivable with a programmeof financial and operational restructuring.Such banks could be nurtured into healthyunits by slowing down on expansion,eschewing high cost funds/borrowings,judicious manpower deployment, recoveryinitiatives, containment of expenditure etc.The future set up of such banks should alsobe given due consideration. Merger could bea solution to the problem of weak banks butonly after cleaning up their balance sheets. Ifthere is no voluntary response to a take overof these banks, it may be desirable to think interms of a Restructuring Commission forsuch public sector banks for consideringother options including restructuring, mergeramalgamation or failing these closure. Sucha Commission could have terms of referencewhich, inter alia, should include suggestionof measures to safeguard the interest ofdepositors and employees and to deal withpossible negative externalities. Weak bankswhich on a careful examination are notcapable of revival over a period of threeyears, should be referred to the Commission.(Chapter V, para 5.16 – 5.18)

In addition to the two definitions foridentifying ‘weak’ banks recommended bythe Committee, RBI monitors banks toidentify ‘potential weakness’ on the basis offive more parameters (related to solvency,profitability and earnings) as recommendedby the Working Group on Restructuring ofWeak Public Sector Banks (Chairman : ShriM.S.Verma ).

In respect of weak banks, a bank-specificrestructuring programme aimed at turningaround the bank by reducing their cost ofoperation, and improving income levels, hasbeen put in place.

The recommendation for setting up of aRestructuring Commission has not beenconsidered. However, the Union Budget for2000 – 2001 has proposed setting up of aFinancial Restructuring Authority for a weakor potentially weak bank.

34. The policy of licensing new privatebanks (other than local area banks) maycontinue. The start up capital requirementsof Rs.100 crore were set in 1993 and thesemay be reviewed. The Committee wouldrecommend that there should be well definedcriteria and a transparent mechanism fordeciding the ability of promoters toprofessionally manage the banks and nocategory should be excluded on a priorigrounds. The question of a minimumthreshold capital for old private banks alsodeserves attention and mergers could be one

The policy of licensing new banks in theprivate sector has been reviewed by an in-house Working Group set up by RBI. Basedon the recommendations of the WorkingGroup, the licensing policy is being revised.

16

of the options available for reaching therequired capital thresholds. The Committeewould also, in this connection, suggest thatas long as it is laid down (as now) that anyparticular promoter group cannot hold morethan 40% of the equity of a bank, any furtherrestriction of voting rights by limiting it to10% may be done away with.(Chapter V,para 5.20)

35. The Committee is of the view that foreignbanks may be allowed to set up subsidiariesor joint ventures in India. Such subsidiariesor joint ventures should be treated on parwith other private banks and subject to thesame conditions with regard to branches anddirected credit as these banks (Chapter V,para 5.21) .

The recommendation has been examined. Ithas been felt that branch presence by foreignbanks would be better for the reason that theparent bank would stand ready to support thebranch in times of distress. Since subsidiarieswould be set up as a joint stock companieswith limited liability, the parent bank’sliability to its subsidiary would be limited toits shareholding. In the case of branches, theparent bank has responsibility both towardscapital and management whereas in the caseof subsidiaries, the parent bank’sresponsibility towards capital is limited.

36. All NBFCs are statutorily required tohave a minimum net worth of Rs.25 lakhs ifthey are to be registered. The Committee isof the view that this minimum figure shouldbe progressively enhanced to Rs.2 croreswhich is permissible now under the statuteand that in the first instance it should beraised to Rs.50 lakhs. (Chapter V, para 5.36)

In respect of new NBFCs, which seekregistration with the RBI and commence thebusiness on or after April 20,1999 the criteriain regard to minimum net worth has beenincreased to Rs.2 crore, vide the Monetaryand Credit Policy for the year 1999-2000.(Circular MPD.BC.185/07.01.279/98-99dated 20th April, 1999).

37. Deposit insurance for NBFCs could blurthe distinction between banks, which aremuch more closely regulated, and the nonbanks as far as safety of deposit is concernedand consequently lead to a serious moralhazard problem and adverse portfolioselection. The Committee would adviseagainst any insurance of deposits withNBFCs.(Chapter V, para 5.38)

The recommendation on not providinginsurance cover for deposits with NBFCs hasbeen noted.

38. RBI should undertake a review of thecurrent entry norms for urban cooperativebanks and prescribe revised prudentminimum capital norms for these banks.Though cooperation is a state subject, sinceUCBs are primarily credit institutions meantto be run on commercial lines, the Committeerecommends that this duality in control

The norms with regard to minimum capitalrequirements for urban cooperativebanks(UCBs) have been revised with effectfrom 1st April, 1998. Implementation of thisrecommendation on doing away with dualityof control over UCBs would involveamendments to State Cooperative SocietiesActs. The Government therefore, has to

17

should be dispensed with. It should beprimarily the task of the Board of FinancialSupervision to set up regulatory standardsfor Urban Cooperative Banks and ensurecompliance with these standards through theinstrumentality of supervision. (Chapter V,para 5.39)

consider.

39. The Committee is of the view that thereis need for a reform of the deposit insurancescheme. In India, deposits are insured uptoRs.1 lakh. There is no need to increase theamount further. There is, however, need toshift away from the 'flat' rate premiums to'risk based' or 'variable rate' premiums.Under risk based premium system all bankswould not be charged a uniform premium.While there can be a minimum flat ratewhich will have to be paid by all banks on alltheir customer deposits, institutions whichhave riskier porfolios or which have lowerratings should pay higher premium. Therewould thus be a graded premium. As theReserve Bank is now awarding CAMELSratings to banks, these ratings could formthe basis for charging deposit insurancepremium. (Chapter V, para 5.42)

This has been accepted for implementation.The Working Group on Deposit Insuranceappointed by RBI has recommended themodalities for switching over to ‘risk based’premium for deposit insurance and therecommendations are under examination.

40. The Committee is of the view that theinter-bank call and notice money market andinter-bank term money market should bestrictly restricted to banks. The onlyexception should be the primary dealerswho, in a sense, perform a key function ofequilibrating the call money market and areformally treated as banks for the purpose oftheir inter-bank transactions. All the otherpresent non-bank participants in the inter-bank call money market should not beprovided access to the inter-bank call moneymarket. These institutions could be providedaccess to the money market through differentsegments.(Chapter V, Annexure para A7)

The phasing out of non-bank participantsfrom inter-bank Call/Notice Money marketwill be synchronized with the development ofrepo market. Keeping in view this objective,RBI has widened the scope of repo market toinclude all entities having SGL Account andCurrent Account in Mumbai, thus increasingthe number of eligible non-bank entities to 64.Further, the permission given to non-bankentities to lend in the call/notice moneymarket by routing their operations throughPDs has been extended upto June, 2001. RBIaims to move towards a pure inter-bank(including PDs) call/notice moneymarket. With a view to further deepening themoney market and enable banks, PDs andAIFIs to hedge interest rate risk, these entitiesare allowed to undertake FRA/IRSs as aproduct for their own balance sheetmanagement and for market making purposes.Mutual Funds, in addition to corporates arealso permitted to undertake FRAs/IRSs with

18

these players. This measure is, inter alia,expected to help development of a termmoney market.

41. There must be clearly defined prudentlimits beyond which banks should not beallowed to rely on the call money market.This would reduce the problem ofvulnerability of chronic borrowers. Access tothe call market should be essentially formeeting unforeseen swings and not as aregular means of financing banks’ lendingoperations (Chapter V, Annexure, para A8).

RBI has advised banks to put in placecomprehensive ALM System with effect from1.4.1999. ALM would effectively put a capon reliance on call money market. DetailedRisk Management Guidelines have also beenissued vide circular DBOD No.BP.BC.98/21.04.103/99 dated 7th Oct. 1999.

42. The RBI support to the market should bethrough a Liquidity Adjustment Facilityunder which the RBI would periodically, ifnecessary daily, reset its Repo and ReverseRepo rates which would in a sense provide areasonable corridor for market play. Whilethere is much merit in an inter-bankreference rate like a LIBOR, such areference rate would emerge as banksimplement sound liquidity managementfacilities and the other suggestions madeabove are implemented. Such a rate cannotbe anointed, as it has to earn its position inthe market by being a fairly stable rate whichsignals small discrete interest rate changesto the rest of the system.(Chapter V,Annexure para A8).

The ILAF (Interim Liquidity AdjustmentFacility) introduced earlier has served itspurpose as a transitional measure forproviding reasonable access to liquid funds atset rates of interest. In view of the experiencegained in operating the interim scheme lastyear, an Internal Group was set up by RBI toconsider further steps to be taken. Followingthe recommendation of the Internal Group, itwas announced in the Monetary and CreditPolicy Measures in April, 2000 to proceedwith the implementation of a full-fledgedLAF. The new scheme will be introducedprogressively in convenient stages in order toensure smooth transition.

? In the first stage, with effect from June5, 2000, the Additional CLF and levelII support to PDs will be replaced byvariable rate repo auctions with sameday settlement.

? In the second stage, the effective datefor which will be decided inconsultation with banks and PDs, CLFand level I liquidity support will alsobe replaced by variable rate repoauctions. Some minimum liquiditysupport to PDs will be continued butat interest rate linked to variable ratein the daily repos auctions asdetermined by RBI from time to time.

? With full computerisation of PublicDebt Office (PDO) and introduction ofRTGS expected to be in place by theend of the current year, in the thirdstage, repo operations throughelectronic transfers will be introduced.In the final stage, it will be possible to

19

operate LAF at different timings of thesame day.

(Cir. MPD.BC. 196/07.01.279/99-2000 dated27.4.2000)

43. The minimum period of FD be reduced to15 days and all money market instrumentsshould likewise have a similar reducedminimum duration.(Chapter V, Annexurepara A9)

The minimum maturity of CDs has beenreduced to 15 days, vide circular DBOD.No.BP.BC. 169/21.01.002/2000 dated 3.5.2000.

44. Foreign institutional investors should begiven access to the Treasury Bill market.Broadening the market by increasing theparticipants would provide depth to themarket (Chapter V, Annexure para A 10)

FIIs have been permitted to invest inTreasury Bills, vide Monetary and CreditPolicy announced in April 1998.(Cir. MPD.BC. 175/07.01.279/97-98 dated29.4.98).

45. With the progressive expansion of theforward exchange market, there should be anendeavour to integrate the forward exchangemarket with the spot forex market byallowing all participants in the spot forexmarket to participate in the forward marketupto their exposures. Furthermore, theforex market, the money market and thesecurities should be allowed to integrateand the forward premia should reflect theinterest rate differential. As instrumentsmove in tandem in these markets thedesiderative of a seamless and vibrantfinancial market would hopefully emerge(Chapter V, Annexure para A 11).

With effect from June 11, 1998 ForeignInstitutional investors were permitted to takeforward cover from Authorised Dealers to theextent of 15 per cent of their existinginvestment as on that date. Any incrementalinvestment over the level prevailing on June11, 1998 was also made eligible for forwardcover. The Monetary and Credit Policy for1999-2000 has further simplified theprocedure by linking the above mentionedlimits to FIIs’ outstanding investments as onMarch 31, 1999. In other words, 15 per centof outstanding investment on March 31, 1999as well as the entire amount – 100 per cent -of any additional investment made after thisdate will be eligible for forward cover.Further, any FII which has exhausted thelimits mentioned above can apply to RBI foradditional forward cover for a further 15 percent of their outstanding investments in Indiaat the end of March 1999.

Rural and Small Industrial Credit :

46. The Committee also recommends that adistinction be made between NPAs arisingout of client specific and institution specificreasons and general (agro-climatic andenvironmental issues) factors. While thereshould be no concession in treatment ofNPAs arising from client specific reasons,

In the event of adverse agro-climatic andenvironmental factors, covering all naturalcalamities, outstanding loans areconverted/rescheduled/rephrased suitably.Agricultural advances so rescheduled areprovided relief for NPA classification. Thedecision to declare a particular crop or

20

any decision to declare a particular crop orproduct or a particular region to be distresshit should be taken purely on techno-economic consideration by a technical bodylike NABARD.(Chapter VI, para 6.6)

product or a particular region as distress hit isat present vested in the concerned DistrictAdministration Authority and the desirabilityof consulting NABARD which is thetechnical body, before taking the decision,would be examined.

47. As a measure of improving the efficiencyand imparting a measure of flexibility thecommittee recommends consideration of thedebt securitisation concept within thepriority sector. This could enable banks,which are not able to reach the prioritysector target to purchase the debt from theinstitutions, which are able to lend beyondtheir mandated percentage.(Chapter VI, para6.8)

The recommendation of the Committee,which basically aims at ensuring that thetarget for priority sector lending is achievedby each of the banks, has been re-examined.As of March 2000, all public sector bankswith the exception of UCO Bank haveachieved the priority sector lending targetindividually and the public sector banks as aGroup has exceeded the target at the macro-level. The UCO Bank is short of achievementonly marginally.Furthermore, every year the Govt. has beensetting up a Rural Infrastructure DevelopmentFund(RIDF) in which all banks which do notachieve the priority sector target contributethe amount of shortfall. Thus all banks,directly or indirectly are able to fulfill thepriority sector lending targets. Though theconcept of debt securitisation is a novel idea,it will not have any practical application sinceit will not help in augmenting the flow ofcredit to the priority sector nor will it help inaddressing the question of regionalimbalances.It has, therefore, been decided that therecommendation need not be considered forthe present.

48. Banking policy should facilitate theevolution and growth of micro creditinstitutions including LABs which focus onagriculture, tiny and small scale industriespromoted by NGOs for meeting the bankingneeds of the poor. Third-tier banks shouldbe promoted and strengthened to beautonomous, vibrant, effective andcompetitive in their operations.(Chapter VI,para 6.16)

In principle approval has been granted forsetting up of 10 Local Area Banks (LABs).Out of these, on account of non-compliancewith the terms and conditions, the ‘inprinciple’ approvals given to 4 banks werewithdrawn. Of the remaining, 4 LABs havealready started functioning after obtaininglicences under Section 22 of BankingRegulation Act, 1949.

49. Banks should devise appropriate criteriasuited to the small industrial sector and beresponsive to its genuine credit needs but thisshould not be by sacrificing cannons of

48 recommendations of the S.L. KapurCommittee conveyed to banks forimplementation. As a further impetus to theflow of credit, banks have been advised that

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sound banking. Borrowers also need toaccept credit discipline. There is also needto review the present institutional set up ofstate level financial/industrial developmentinstitutions.(Chapter VI, para 6.19).

the credit requirement of SSIs having creditlimits upto Rs.5 crore, instead of Rs.4 crore,may be assessed on the basis of 20% of theprojected annual turnover.

Regulation and Supervision :

50. The Committee recommends that toimprove the soundness and stability of theIndian banking system, the regulatoryauthorities should make it obligatory forbanks to take into account risk weights formarket risks. The movement towards greatermarket discipline in a sense would transformthe relationship between banks and theregulator. By requiring greater internalcontrols, transparency and market discipline,the supervisory burden itself would berelatively lighter.(Chapter VII, para 7.13)

Banks are now required to assign capital formarket risk. Please see comments against item1 above.As indicated against item 19 above, thedisclosure requirements of banks have beenstrengthened.

51. There is a need for all marketparticipants to take note of the coreprinciples and to formally announce fullaccession to these principles and their fulland effective implementation.(Chapter VII,para 7.14)

We have endorsed the ‘Core Principles forEffective Banking Supervision’ and compliedwith almost all of them. Our compliance withthe Core Principles has been rated assatisfactory by IMF Mission.

52. Proprietorial concerns in the case ofpublic sector banks impact on the regulatoryfunction leading to a situation of ‘regulatorycapture’ affecting the quality ofregulation.(Chapter VII, para 7.16)

The prudential / regulatory norms stipulatedby RBI are applicable to public sector banks,private sector banks and foreign banksuniformly.

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53. The Committee recommends that theregulatory and supervisory authoritiesshould take note of the developments takingplace elsewhere in the area of devisingeffective regulatory norms and to apply themin India taking into account the specialcharacteristics but not in any waydiluting the rigour of the norms so thatthe prescriptions match the best practicesabroad. It is equally important to recognisethat pleas for regulatory forbearance such aswaiving adherence to the regulations toenable some (weak) banks more time toovercome their deficiencies could onlycompound their problems for the future andfurther emasculate their balancesheets.(Chapter VII, para 7.17)

The Regulatory / Supervisory norms havebeen formulated taking into account the bestinternational practices. RBI has not waivedadherence to the regulatory norms by anyindividual bank or category of banks.

54. An important aspect of regulatoryconcern should be ensuring transparencyand credibility particularly as we move intoa more market driven system where themarket should be enabled to form itsjudgement about the soundness of aninstitution. There should be punitivepenalties both for the inaccurate reporting tothe supervisor or inaccurate disclosures tothe public and transgressions in spirit of theregulations.(Chapter VII, para 7.19).

We are moving towards greater transparencyand Statutory Auditors of banks are nowunder the obligation to report on thedeviations from adherence to the prudentialnorms prescribed by RBI in their ‘Notes toAccounts’. These observations are followedup by the RBI with the concerned banks. Interms of the provisions of Section 47A of theB.R. Act, 1949, as amended in 1994, the RBIcan impose a penalty not exceeding Rs. 5 lakhor twice the amount involved in suchcontravention or default where such amount isquantifiable whichever is more and wheresuch contravention or default is a continuingone, a further penalty which may extent to Rs.25,000 for every day after the first day whenthe contravention or default continues.

55. The Committee is of the view that banksshould be required to publish half yearlydisclosure requirements in two parts. Thefirst should be a general disclosure,providing a summary of performance over aperiod of time, say 3 years, including theoverall performance, capital adequacy,information on the bank’s risk managementsystems, the credit rating and any action bythe regulator/supervisor. The disclosurestatement should be subject to full externalaudit and any falsification should invitecriminal procedures. The second disclosure,which would be a brief summary aimed at

- dbs -

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the ordinary depositor/ investor shouldprovide brief information on matters such ascapital adequacy ratio, non performingassets and profitability, vis-à-vis, theadherence to the stipulated norms and acomparison with the industry average. Thissummary should be in a language intelligibleto the depositor and be approved by thesupervisors before being made fully publicwhen soliciting deposits. Such disclosure, theCommittee believes, will help the strongbanks to grow faster than the weaker banksand thus lead to systematicimprovement.(Chapter VII, para 7.20)

56. The Committee recommends that anintegrated system of regulation andsupervision be put in place to regulate andsupervise the activities of banks, financialinstitutions and non banking financecompanies (NBFCs). The functions ofregulation and supervision are organicallylinked and we propose that this agency berenamed as the Board for FinancialRegulation and Supervision (BFRS) to makethis combination of functions explicit. Anindependent regulatory supervisory systemwhich provides for a closely coordinatedmonetary policy and banking supervisionwould be the ideal to work towards.(ChapterVII, para 7.24).

BFS needs to be strengthened beforeregulatory functions are vested with it. It was,therefore, felt that while the Committee’srecommendations to set up an agency namedBoard for Financial Regulation andSupervision (BFRS) to provide an integratedsystem of regulation and supervision overbanks, FIs and NBFCs could be a long termobjective. For the time being, BFS maycontinue with its present mandate.

57. The Board for Financial Regulation andSupervision (BFRS) should be givenstatutory powers and be reconstituted in sucha way as to be composed of professionals. Atpresent, the professional inputs are largelyavailable in an advisory board which acts asa distinct entity supporting the BFS.Statutory amendment which would give thenecessary powers to the BFRS shoulddevelop its own autonomous professionalcharacter. The Committee, taking note of theformation of BFS, recommends that theprocess of separating it from the ReserveBank qua central bank should begin and theBoard should be invested with requisiteautonomy and armed with necessary powersso as to allow it to develop experience andprofessional expertise and to function

Please see comments against item 56 above.

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effectively. However, with a view to retainan organic linkage with RBI, the Governor,RBI should be head of the BFRS. TheCommittee has also set out specific measuresto ensure an effective regulatory/supervisorysystem which are detailed in para 7.27(Chapter VII, para 7.24)

Legal and Legislative Framework :

58. With the advent of computerisation thereis need for clarity in the law regarding theevidentiary value of computer generateddocuments. The Shere Committee had madesome recommendations in this regard andthe Committee notes that the Government ishaving consultations with public sectorbanks in this matter. With electronic fundstransfer several issues regardingauthentication of payment instruments, etc.require to be clarified. The Committeerecommends that a group be constituted bythe Reserve Bank to work out the detailedproposals in this regard and implement themin a time bound manner. (Chapter VIII, para.8.15 8.16)

The Group set up by the RBI has submittedits Report and the recommendations are invarious stages of implementation.

59. Although there is a provision in ourlegislation effectively prohibiting loans bybanks to companies in which their directorsare interested as directors or employees ofthe latter with liberalisation and theemergence of more banks on the sceneand with the induction of private capitalthrough public issue in some of thenationalised banks there is a possibility thatthe phenomenon of connected lending mightreappear even while adhering to the letterof law. It is necessary to have prudentialnorms which are addressed to thisproblem by stipulating concentration ratiosin terms of which no bank can have morethan a specified proportion of its net worthby way of lending to any single industrialconcern and a higher percentage in respectof lending to an industrial group. At present,lending to any single concern is limited to25% of a bank’s capital and free reserves.This would seem to be appropriate along

As the Committee has noted, Section 20 ofthe Banking Regulation Act, 1949 prohibitsbanks from entering into any commitment forgranting of any loan or advance to or onbehalf of any of its directors, any firm inwhich any of its directors is interested aspartner, manager, employee or guarantor orany company of which any of the directors ofthe banking company is a director, managingagent, manager, employee, or guarantor or inwhich he holds substantial interest or, anyindividual in respect of whom any of itsdirectors is a partner or guarantor.

The RBI has, as noted by the Committee, laiddown prudential ceilings on exposures tosingle / group of borrowers.

Banks on their own, have also prescribedexposure ceilings on single borrower andgroup of borrowers.

25

with the existing enhanced figure of 50% forgroup exposure except in the case ofspecified infrastructure projects. Similarly,concentration ratios would need to beindicated, even if not specifically prescribed,in respect of any bank’s exposure to anyparticular industrial sector so that in theevent of cyclical or other changes in theindustrial situation, banks have an element ofprotection from over exposure in that sector.Prudential norms would also need to be setby way of prescription of exposure limits tosectors particularly sensitive to asset pricefluctuations such as stock markets and realestate. As it happens, Indian banks do nothave much exposure to the real estate sectorin the form of lending for propertydevelopment as distinct from making housingloans. The example of banks in East andSouth East Asia which had over extendedthemselves to these two sectors has onlyconfirmed the need for circumspection in thisregard. We would leave the precisestipulation of these limits and, if necessary,loan to collateral value ratios to theauthorities concerned. The implementation ofthese exposure limits would need to becarefully monitored to see that they areeffectively implemented and notcircumvented, as has sometimes happenedabroad, in a variety of ways. Anothersalutary prescription would be to require fulldisclosure of connected lending and lendingto sensitive sectors. (Chapter III, para. 3.40)

As regards the recommendation thatprudential norms be set by way ofprescription of exposure limits to sensitivesectors, i.e. those sectors where asset pricesare subject to fluctuations, RBI has alreadyput in place a cap on a bank’s exposure toshare market. The banks on their own havelimited their exposure to real estate business.Banks are expected to set norms for lendingto any particular industrial sector in theirlending policy. Banks have been advised todisclose in ‘Notes on Account’ to theirbalance sheets, lending to sensitive sectors,(i.e., advances to sectors such as, capitalmarket, real estate, etc.) and such othersectors to be defined as ‘sensitive’ by RBIfrom time to time with effect from the yearended March 31, 2000.(Cir. DBOD.No.BP.BC.9/21.04.018/99 dt.10February, 1999).

60. The Committee recommends that toimprove the soundness and stability of theIndian banking system, the regulatoryauthorities should make it obligatory forbanks to take into account risk weights formarket risks. The movement towards greatermarket discipline in a sense would transformthe relationship between banks and theregulator. By requiring greater internalcontrols, transparency and market discipline,the supervisory burden itself would berelatively lighter.(Chapter VII, para. 7.13 )

Please see comments against item 1 above.

61. The Committee recommends that the RBIshould totally withdraw from the primary

The withdrawal of RBI from the primarymarket in 91 day Treasury Bills is the long

26

market in 91 days Treasury Bills; the RBIcould, of course, have a presence in thesecondary market for 91 days Treasury Bills.If the 91 days Treasury Bill rate reflectsmoney market conditions, the money andsecurities market would develop an integrallink. … .The Committee also recommends thatforeign institutional investors should begiven access to the Treasury Bill market.(Chapter V, Annexure, para. A-10 )

term objective. The pace of implementation ofthe recommendation should depend upon thedevelopment and depth of the Govt.securities market. One of the objectives ofevolving the system of Primary Dealers is toimprove the underwriting and market makingcapabilities in Government securities marketso that RBI could eventually withdraw fromprimary subscriptions. This will be possibleonly when Primary Dealers are capable oftaking devolvement, if any, to the full extent.

As regards giving access to FIIs to theTreasury Bill market it has beenimplemented. ((Cir. MPD.BC.175/07.01.279/97-98 dated 29.4.98).

d) Recommendations on which a view has to be taken by Govt.

(i) So far, a sum of Rs.20,000 crore has beenexpended for recapitalisation and to theextent to which recapitalisation has enabledbanks to write off losses, this is the costwhich the Exchequer has had to bear for thebad debts of the banks. Recapitalisation is acostly and, in the long run, not a sustainableoption. Recapitalisation involves budgetarycommitments and could lead to a largemeasure of monetisation. The Committeeurges that no further recapitalisation ofbanks be undertaken from the Governmentbudget. As the authorities have alreadyproceeded on the recapitalisation route it isperhaps not necessary to consider de novothe institution of an ARF of the typeenvisaged by the earlier CFS Report. Thesituation would perhaps have been differentif the recapitalisation exercise had not beenundertaken in the manner in which it hasbeen.(Chapter III, para. 3.24 – 3.25)

Govt. to reply

(ii) As an incentive to banks to make specificprovisions, the Committee recommends thatconsideration be given to making suchprovisions tax deductible. (Chapter III, para.3.39)

-do-

(iii) It would be appropriate if themanagement committees are reconstituted to -do-

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have only whole time functionaries in it,somewhat on the pattern of Central OfficeCredit Committee constituted in the StateBank of India. All decisions taken by thesecommittees could be put up to the Board ofDirectors for information.(Chapter IV, para.4.12 – 4.16)

(iv) It would be appropriate to induct anadditional whole time director on the Boardof the banks with an enabling provision formore whole time directors for bigger banks.(Chapter IV, para.4.17)

-do-

(v) There are opportunities of outsourcing inother activities like building maintenance,cleaning, security, despatch of mail andmore importantly, in computer related areas.The Committee has been informed that insome areas banks are unable to subcontractwork because of a notification issued by theLabour Ministry under Contract Labour(Regulation and Abolition) Act, 1970. TheCommittee would urge that this be lookedinto by the authorities so that banks areenabled to effect efficiency and productivityimprovements. The global trend in thebanking and financial sector also reflects anincreasing reliance on outsourced services.In an increasingly competitive environment,statutory provisions should not lead to bankshaving to carry on internally functions andtasks which can be performed moreefficiently by outside service provides.(Chapter IV, para. 4.18).

-do-

(vi) The Committee feels that the issue ofremuneration structure at managerial levelsprevailing in public sector banks andfinancial institutions needs to be addressed.There is an urgent need to ensure thatpublic sector banks are given flexibility todetermine managerial remuneration levelstaking into account market trends. TheCommittee recommends that the necessaryauthority in this regard be given to theBoards of the banks initially in the case ofprofit making public sector banks whichhave gone public, for they would, in anycase, be required to operate with an

The recent wage settlement of bank staffwith Unions has broadly kept this in viewand leaving the decision on other perquisitesto the potential of individual banks concerned.

Govt. to reply.

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accountability to the market. Theforthcoming wage negotiations provide anopportunity to review the existing pattern ofindustry-wise negotiations and move over tobank-wise negotiations.(Chapter IV, para.4.26 )

(vii) This Committee is of the view that intoday's increasingly challenging businessenvironment, a large institution can only beled effectively by a Chief Executive who hasa reasonable length of tenure, which theCommittee believes should not be less thanfive years. Since, however, moving over tothis tenure may be difficult, we suggest thatin the first instance, the minimum tenureshould be three years. The Committee feelsthat there is now a need to delink the payscales of the Chief Executives of publicsector banks and financial institutions fromthe Civil Service pay scales and that thisshould be left to be decided by the individualbanks, not excluding the possibility ofperformance based remuneration. TheCommittee would like to add that theseobservations and recommendations alsoapply to the whole time Directors on theBoards of banks and financial institutionsappointed by the Government.(Chapter IV, para.4.29 – 4.30 )

The recommendation pertaining to reasonablelength of tenure for the Chief Executive hasbeen implemented while appointing the newChairmen of PSBs. As regards therecommendation regarding delinking of payscales of Chief Executives of public sectorbanks from that of the Civil Service, this willhave to be considered by the Government.

(viii) There may be need to redefine thescope of external vigilance and investigativeagencies with regard to banking business.External agencies should have the requisiteskill and expertise to take into account thecommercial environment in which decisionsare taken. The vigilance manual now beingused has been designed mainly for use byGovernment Departments and public sectorundertakings. It may be necessary that aseparate vigilance manual which capturesthe special features of banking should beprepared for exercising vigilance supervisionover banks. The Committee feels that this isan extremely critical area and arrangementssimilar to the Advisory Board for BankFrauds be made for various levels of staff ofbanks.(Chapter IV, para. 4.35 – 4.37)

A separate chapter capturing special featuresof banking transactions has been incorporatedin the Vigilance Manual.

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(ix) The Committee attaches the greatestimportance to the issue of functionalautonomy with accountability within theframework of purposive, rule bound, non-discretionary prudential regulation andsupervision. Autonomy is a prerequisite foroperational flexibility and for criticaldecision making whether in terms of strategyor day to day operations. There is also thequestion whether full autonomy withaccountability is consistent and compatiblewith public ownership. Given the dynamiccontext in which the banks are operating andconsidering the situational experiencefurther capital enhancement would benecessary for the larger Indian banks.Against the background of the need for fiscalconsolidation and given the many demandson the budget for investment funds in areaslike infrastructure and social services, itcannot be argued that subscription to theequity of public sector banks to meet theirenhanced needs for capital should commandpriority. Public sector banks should beencouraged, therefore, to go to the market toraise capital to enhance their capital. Atpresent, the laws stipulate that not less than51% of the share capital of public sectorbanks should be vested with the Governmentand similarly not less than 55% of the sharecapital of the State Bank of India should beheld by the Reserve Bank of India.

The current requirement of minimumGovernment of India/Reserve Bank of Indiashareholding is likely to become a constraintfor raising additional capital from the marketby some of the better placed banks unlessGovernment also decides to providenecessary budgetary resources toproportionately subscribe to the additionalequity, including the necessary premium onthe share price, so as to retain its minimumstipulated shareholding. The Committeebelieves that these minimum stipulationsshould be reviewed. It suggests that theminimum shareholding by Government/RBIin the equity of nationalised banks and SBIshould be brought down to 33%.

Banks have been given further autonomy inmatters relating to their business operations.These relate to greater autonomy to openbranches, freedom to charge interest onadvances as also on deposits, recruitment ofspecialist officers and other matters ofcorporate strategy.

Public sector banks are encouraged to go tothe market raise capital to enhance theircapital. Eleven public sector banks have sinceaccessed the capital market for raisingadditional capital.

The recommendation has been accepted. TheBill to bring down the shareholding of theGovt. of India in nationalised banks has beenintroduced in Parliament.

The recommendation in regard to bringingdown shareholding of the Govt. of India innationalized banks to 33% has been accepted.A Bill has been introduced in the Parliamentfor the purpose.

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The Reserve Bank as a regulator of themonetary system should not be also theowner of a bank in view of the potential forpossible conflict of interest. It would benecessary for the Government/RBI to divesttheir stake in these nationalised banks and inthe State Bank of India. A reduction in theirshares would come about through additionalsubscription by the market to their enhancedcapital. A portion of upto 5 or 10% of theequity of the bank concerned may bereserved for employees of the bank with aprovision of some later date for theintroduction of stock options. Theappointment by the Government of Boardsand top executives of banks derives from itsmajority holding and if, as suggested above,the majority holding itself were to be givenup, the appointment of Chairmen andManaging Directors should be left to theBoards of the banks and the Boardsthemselves left to be elected by shareholders.

Needless to say, with a significant stockholding of not less than 33% Governmentwould have a say in the election of Boardsand indirectly of the chief executives withouttheir being seen as administrativeappointments. The reduction in the minimumholding of Government below 51% would initself be a major and clear signal about therestoration to banks and financialinstitutions of autonomy in their functioning.The Committee makes this recommendationin the firm belief that this is essential forenhancing the effectiveness and efficiency ofthe system and not on any otherconsideration.(Chapter V, para 5.27 – 5.33)

Govt. to reply.

Govt. to reply.

(x) To provide the much needed flexibilityin its operations, IDBI should becorporatised and converted into a Joint StockCompany under the Companies Act on thelines of ICICI, IFCI and IDBI. For providingfocussed attention to the work of StateFinancial Corporations, IDBI shareholdingin them should be transferred to SIDBI whichis currently providing refinance assistance toState Financial Corporations. To give itgreater operational autonomy, SIDBI should

Govt. to reply.

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also be delinked from IDBI (Chapter V, para5.34).

(xi) Though cooperation is a state subject,since UCBs are primarily credit institutionsmeant to be run on commercial lines, theCommittee recommends that this duality incontrol should be dispensed with. It shouldbe primarily the task of the Board forFinancial Supervision to set up regulatorystandards for Urban Cooperative banks andensure compliance with these standardsthrough the instrumentality of supervision.(Chapter V, para 5.39)

Govt. to reply

(xii) The Committee is of the view that thebanking system should be in a position toequip itself to identify the eligible clientsbased on prescribed norms in theGovernment sponsored programmes so thatthe full responsibility for all aspects of thecredit decision remains with it. This shouldalso help improve the client bankrelationship instead of the present system ofvirtually imposed clientele and build a creditculture and discipline . (Chapter VI, para6.3)

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(xiii) The Committee strongly urges thatthere should be no recourse to any scheme ofdebt waiver in view of its serious anddeleterious impact on the culture of credit.(Chapter VI, para 6.7)

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(xiv) Evolution of a risk management systemwould provide the needed comfort to thebanking system to finance agriculture. Atpresent, under the Income Tax Act, provisionfor bad and doubtful debts not exceeding 5%of income and 10% of the aggregate averageadvances made by rural branches of ascheduled or a non scheduled bank areallowed as deduction in computing theincome chargeable to tax. Considerationcould be given to increasing this to 5% ofincome and 20% of average aggregateadvances of rural branches to provideincentive to banks for lending to ruralsectors.(Chapter VI, para 6.10)

-do-

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(xv) The Committee recommends that theRRBs and cooperative banks should reach aminimum of 8% capital to risk weightedassets over a period of five years. A review ofthe capital structure of RRBs should beundertaken with a view to enlarging publicsubscription and give the sponsor banksgreater ownership and responsibility in theoperation of RRBs. While considering theissue of salaries of employees of RRBs theCommittee strongly urges that there shouldbe no further dilution of the basic feature ofRRBs as low cost credit delivery institutions.Cooperative credit institutions also need toenhance their capital through subscriptionby their members and not by Government.There should be a delayering of thecooperative credit institutions with a view toreducing the intermediation cost and thusproviding the benefit of cheaper NABARDcredit to the ultimate borrowers. (ChapterVI, para 6.12 )

This recommendation has been accepted inprinciple. Govt. of India is alsocontemplating suitable amendments to RRBAct,1976 to facilitate further restructuring ofRRBs involving changes in capital structure,ownership, etc. Pending amendments to RRBAct, sponsor banks have been entrusted withgreater powers to guide and monitor theoperations of RRBs. As regards the salarystructure of employees of RRBs, the S.L.Mahalik Committee appointed by ReserveBank of India has made certainrecommendations on restructuring of the payscales of RRB employees and these have beenforwarded to the Govt. for consideration. Asregards delayering of cooperative creditstructure, the suggestion would be forwardedto NABARD for detailed examination. Govt.will have to consider amendment to theCooperative Societies Act.

(xvi) The supervisory function over ruralfinancial institutions has been entrusted toNABARD. While this arrangement maycontinue for the present, over the longerterm, the Committee would suggest that allregulatory and supervisory functions overrural credit institutions should vest with theBoard for Financial Regulation andSupervision.( Chapter VI para 6.13 )

Govt. to reply since implementation of therecommendation would require amendmentsto relevant Acts.

(xvii) The present duality of control over thecooperative credit institutions by StateGovernment and RBI/NABARD should beeliminated and all the cooperative bankinginstitutions should come under the disciplineof Banking Regulation Act, under the aegis ofRBI/NABARD/BFS. Thus would requireamendments to the Banking Regulation Act.The control of the Registrar of cooperativesector over cooperatives would then besomewhat on the lines of control thatRegistrar of Companies has over the BankingInstitutions, registered under the CompaniesAct.(Chapter VI, para 6.14 )

Govt. to reply since implementation of therecommendation would require amendmentsto relevant Acts.

(xviii) A legal framework that clearlydefines the rights and liabilities of parties to

Govt. to reply.

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contracts and provides for speedy resolutionof disputes is essential for financialintermediation. The evolution of the legalframework has not kept pace with thechanging commercial practices and with thefinancial sector reforms. The Transfer ofProperty Act enacted in 1882 is a case inpoint.(Chapter VIII, para 8.1 )

(xix) Given the unsatisfactory state of thelaw of mortgage, the response has been tovest through special statute the power of salein certain institutions like Land DevelopmentBanks and State Finance Corporations. Thisapproach could be extended to otherfinancial institutions and, if possible, tobanks. The other approach is to set upspecial tribunals for recovery of dues tobanks and financial institutions. TheseTribunals need to have powers of attachmentbefore judgement, for appointment ofreceivers and for ordering preservation ofproperty. For this purpose, an amendment tothe concerned legislation may be necessary.The Committee would like to emphasise theimportance of having in place a dedicatedand effective machinery for debt recovery forbanks and financial institutions.(ChapterVIII, para 8.2 – 8.4 )

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(xx) Securitisation of mortgages is alsocritically dependent on the ease ofenforcement and the costs associated withtransfer of mortgages. The power of salewithout judicial intervention is not availableto any class of mortgages except where themortgages is the Government or themortgage agreement so provides and themortgaged property is situated in Mumbai,Chennai and Calcutta and other towns sonotified. Even if the power of sale withoutjudicial intervention were available therewould need to be measure to put the buyer inpossession. (Chapter VIII, para 8.5 – 8.6 )

Govt. to reply.

(xxi) The question of stamp duties andregistration fees also requires review. Thereis a case for reducing stamp duties andregistration fees substantially.(Chapter VIII,para 8.7 )

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(xxii) In view of the recent amendments toSection 28 of Indian Contract Act, bankshave expressed a fear that they can no longerlimit their liabilities under bank guaranteesto a specified period and that they wouldhave to carry such guarantee commitmentsfor long periods as outstanding obligations.Government departments do not generallyreturn the original guarantee papers evenafter the purpose is served. This whole issueneeds to be re-examined and bankguarantees exempted from the purview of therecent amendment to Section 28 of theIndian Contract Act. The issue of enforcingsecurities in the form of book debts also callsfor review. The Committee also agrees withthe proposal to amend the Sick IndustrialCompanies Act, seeking to trigger off theremedial mechanism on the sight of incipientsickness.(Chapter VIII, para 8.9 – 8.14)

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(xxiii) Certain legislative requirements wouldalso be needed to implement some of theCommittee's recommendations regarding thestructure of the banking system and matterspertaining to regulation and supervision. TheBanking Regulation Act is structured on thepremise that bank supervision is essentially aGovernment function and that the ReserveBank of India’s position is somewhat on thelines of an agent. The Act also providesappellate powers to Government over thedecisions of the RBI in this regard. It alsoprovides original powers in certaininstances. The Committee feels that theseprovisions should be reviewed. (ChapterVIII, para8.17)

Govt. to reply

(xxiv) With respect to recommendationsregarding constitution of a Board forFinancial Regulation and Supervision, itwould be necessary for amendments in theBanking Regulation Act and Reserve Bank ofIndia Act. Amendments would also beneeded in the Bank Nationalisation Acts toenable grant of greater managerial

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autonomy to public sector banks for loweringthe minimum requirements of 51%Government ownership and as regards theconstitution of Boards of Directors and of theManagement Committees. The provisionsrelating to prior approval of Government forregulations framed under the Act would alsoneed to be reviewed. In line with the above,amendments would also be needed in theState Bank of India Act with regard toshareholding of the RBI and constitution ofits Central Board. (Chapter VIII, para 8.19 –8.23 )

(xxv) These suggestions are not exhaustiveand we would recommend that the legalimplications with reference to each of theserecommendations be examined and detailedlegislative steps identified by the Ministry ofFinance, Banking Division in consultationwith the Ministry of Law. In view or thewide-ranging changes needed in the legalframework the Committee recommendssetting up of an expert Committee comprisingamong others, representatives from theMinistry of Law, Banking Division, Ministryof Finance, RBI and some outside experts toformulate specific legislative proposals togive effect to the suggestions made above.(Chapter VII, para 8.22 – 8.23)

An Expert Legal Group under thechairmanship of Shri. T. R. Andhyarujina,former Solicitor General, was set up . TheGroup’s report is under examination of theGovt. of India.

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