IMPACT OF BASEL & OTHER INDIAN COMMITTEES RECOMMENDATIONS ON INDIAN BANKING SYSTEM
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Transcript of IMPACT OF BASEL & OTHER INDIAN COMMITTEES RECOMMENDATIONS ON INDIAN BANKING SYSTEM
1
A PROJECT REPORT ON
IMPACT OF BASEL & OTHER INDIAN COMMITTEES
RECOMMENDATIONS ON INDIAN BANKING SYSTEM
In partial fulfillment of the Dissertation
In Semester - IV of the Master of Business Administration
Prepared by:
Aayush Kumar
Registration No: 13010121218
Under the Guidance of
Prof. Shivaprasad.G
Bangalore
2
Master of Business Administration
Declaration
This is to declare that the report entitled “IMPACT OF BASEL & OTHER INDIAN
COMMITTEES RECOMMENDATIONS ON INDIAN BANKING SYSTEM” is prepared
for the partial fulfillment of the Dissertation course in Semester IV of the Master
of Business Administration by me under the guidance of Prof. Shivaprasad.G.
I confirm that this dissertation truly represents my work. This work is not a
replication of work done previously by any other person. I also confirm that the
contents of the report and the views contained therein have been discussed and
deliberated with the Faculty Guide.
Signature of the Student :
Name of the Student : AAYUSH KUMAR
Registration No : 13010121218
3
Master of Business Administration
Certificate
This is to certify that Mr. Aayush Kumar Regn. No. 13010121218 has completed
the dissertation titled IMPACT OF BASEL & OTHER INDIAN COMMITTEES
RECOMMENDATIONS ON INDIAN BANKING SYSTEM under my guidance for the
partial fulfillment of the Dissertation course in Semester IV of the Master of
Business Administration
Signature of Faculty Guide:
Name of the Faculty Guide: Prof. SHIVAPRASAD. G
4
CONTENTS
Chapter Page no.
Abstract
List of Tables
List of Charts
1. INTRODUCTION………………………………………………8-28
1.1 Statement of BASEL Norms
1.2 Introduction of Narasimham Committee
1.3 Introduction of Raghuram Rajan Committee
1.4 Introduction of Indian Banking System
2. RESEARCH METHODOLOGY……………………………...29-33
2.1 Need of the Study
2.2 Research Design and Survey Design
2.3 Data Analysis
2.4 Research Methodology
2.5 Research Design
2.6 Project Objectives
2.7 Expected Outcomes
3. DATA ANALYSIS……………………………………………...34-71
3.1 BASEL III
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3.2 Impact of BASEL III on Loan Spreads
3.3 Impact of BASEL III on Bank Capital
3.4 Narasimham Committee Recommendations and Action
3.5 Raghuram Rajan Committee Report Analysis
4. CONCLUSION & FINDINGS………………………………...72-84
4.1 BASEL III
4.2 Narasimham Committee
4.3 Raghuram Rajan Committee
5. REFERENCES…………………………………………………85-86
6
LIST OF CHARTS/DIAGRAMS
SR NO PARTICULARS PG NO
1 Structure of Indian Banking 22
2 Core Banking Sector Indicators in India 24
3 Interest Rates in India 25
4 Capital to Risk Weighted Assets Ratio-Bank GroupWise 25
5 CRAR Levels of Indian Banking 35
6 CRAR Levels of Indian Banking 41
LIST OF TABLES
SR NO PARTICULARS PG NO
1 Comparison of Capital Requirement Standards 34
2 Deductions from Capital BASEL III guidelines Vs. Existing RBI
Norms
34-35
3 Sample Distribution by Category of Scheduled Commercial Banks
in India
38-39
4 Stylized Balance sheet and Income Statement of Scheduled
Commercial Banks
39
5 Levels of Capital Adequacy Ratios of Banks in selected Economies 40
6 Comparison of Capital Requirement Standards 41-42
7 Deductions from Capital BASEL III guidelines Vs. Existing RBI
Norms
42-43
8 Impact of Key Factors of Capital Standards on Equity 43-44
9 Possible Impact of Capital Standards on Indian Banks 44
10 BASEL III compliance – Required Minimum Capital 45
11 Comparison of Results for Estimations of Bank Loan Spread for
SCBs
71-72
12 Comparison of Results for Estimations of Bank Loan Spread for
SCBs
72
13 Increase in Bank Lending Spreads for a One Percentage Point
Increase in Bank Capital
72
14 Summary of Findings of Different Studies on Capital Requirement
of Indian Banks
73
15 Cost Benefit Analysis of BASEL III for Indian Banking 74
7
ABSTRACT
The impacts of the global financial crisis coupled with domestic policy paralysis have dented
India’s growth prospects much more than what had been predicted. The implementation of
Basel III norms would considerably enhance the regulatory capital requirement of Indian
banks apart from subjecting them to rigorous regulatory monitoring. Undoubtedly, the
increased capital requirements would result in the increase in the cost to banks as well as to
borrowers. Given this context, this research project has adequately assessed the impact of the
new capital requirements introduced under the Basel III framework on bank lending rates
and loan growth and also estimated the extent of higher capital requirements for the Indian
banks.
This study has been successful in broadening and deepening the understanding of the
potential impact of Basel III framework along with other committee’s recommendations by
estimating the qualitative as well as quantitative impact of Basel III. This study observes that
new capital requirements under Basel III would have positive impact for Indian banks as they
raise the minimum core capital, introduce counter-cyclical measures, and enhance banks’
ability to conserve core capital in the event of stress through a conservation capital buffer. The
liquidity standard requirements would benefit the banks in managing the pressures on
liquidity in a stress scenario more effectively.
The study has estimated that the impact of Basel III on bank loan spreads would be 31 basis
points increase for every 1-percentage point increase in capital ratio and would go up to an
extent of 100 basis points for 6-percentage point increase in the capital ratio assuming that the
Risk weighted assets are unchanged. However, assuming the risk weighted assets to decline by
20 percent; the study finds that there would be 22 basis points increase for every 1-percentage
point increase in capital ratio and would go up to an extent of 68 basis points for 6-percentage
point increase in the capital ratio.
Estimating the additional capital requirements of Indian banks in the wake of Basel III
regime, this study estimates that with an assumed growth of RWAs at 10%, Indian banks
would require additional minimum tier-1 capital of INR 251106.57 Crores, and with RWAs
growth at 12% and 15%, the requirement is estimated to be respectively in the order of INR
336390.41 Crores and INR 474168.60 Crores.
It was one of the objectives of this study to make a cost-benefit analysis of the implementation
of Basel III in the Indian context. Accordingly, it is estimated that while the requirement of
additional minimum tier-1 capital would be INR 2,51,106 crores with RWAs assumed at 10%,
the probable prevention of loss-in-output due to a crisis (at a very conservative estimation)
would be in the range of INR 16,01,971 crores.
8
CHAPTER 1
INTRODUCTION
9
1.1 INTRODUCTION OF BASEL NORMS:
The Basel Banking Accords are norms issued by the Basel Committee on Banking Supervision
(BCBS), formed under the auspices of the Bank of International Settlements (BIS), located in
Basel, Switzerland. The committee formulates guidelines and makes recommendations on best
practices in the banking industry. The Basel Accords, which govern capital adequacy norms of
the banking sector, aim to ensure financial stability and thereby increase risk absorbing
capability of the banks.
The first set of Basel Accords, known as Basel I, was issued in 1988, with primary focus on
credit risk. It laid the foundation of risk weighting of assets and set objective targets of capital to
be maintained. Basel II was issued in 2004 with the objective of being more comprehensive. It
aimed at increasing capital adequacy by imposing a buffer for a larger spectrum of risk. As time
has gone by, we have witnessed the Basel norms failing to restrict two major crisis during its
tenure, the South Asian Crisis in 1998 and Sub-prime Mortgage Crisis in 2007, which raises
questions about its effectiveness. As the banking world prepares to comply with Basel III, the
effectiveness of the Basel accord has come under the radar.
The Committee seeks to achieve its aims by setting minimum supervisory standards; by
improving the effectiveness of techniques for supervising international banking business; and by
exchanging information on national supervisory arrangements. And, to engage with the
challenges presented by diversified financial conglomerates, the Committee also works with
other standard-setting bodies, including those of the securities and insurance industries.
The Committee's decisions have no legal force. Rather, the Committee formulates supervisory
standards and guidelines and recommends statements of best practice in the expectation that
individual national authorities will implement them. In this way, the Committee encourages
convergence towards common standards and monitors their implementation, but without
attempting detailed harmonization of member countries' supervisory approaches.
At the outset, one important aim of the Committee's work was to close gaps in international
supervisory coverage so that (i) no foreign banking establishment would escape supervision; and
(ii) that supervision would be adequate and consistent across member jurisdictions. A first step in
this direction was the paper issued in 1975 that came to be known as the "Concordat", which set
out principles by which supervisory responsibility should be shared for banks' foreign branches,
subsidiaries and joint ventures between host and parent (or home) supervisory authorities. In
May 1983, the Concordat was revised and re-issued as Principles for the supervision of banks'
foreign establishments .
In October 1996, the Committee released a report on The supervision of cross-border banking,
drawn up by a joint working group that included supervisors from non-G10 jurisdictions and
offshore centres. The document presented proposals for overcoming the impediments to effective
consolidated supervision of the cross-border operations of international banks. Subsequently
endorsed by supervisors from 140 countries, the report helped to forge relationships between
supervisors in home and host countries.
10
Basel – I
Basel I Accord attempts to create a cushion against credit risk. It comprises of four pillars,
namely
Constituents of Capital: It prescribes the nature of capital that is eligible to be treated as
reserves.
Risk Weighting: Risk Weighting created a comprehensive system to provide weights to
different categories of bank’s assets (on balance sheet as well as off balance sheet assets)
on the basis of relative riskiness.
Target Standard Ratio: This acted as a unifying factor between the first two pillars. A
universal standard of 8% coverage of risk weighted assets by Tier I and II capital was set,
with at least 4% being covered by Tier I capital alone.
Transitional & implementing arrangements: Phase wise implementation deadlines were
set wherein a target of 7.25% was to be achieved by the end of 1990 and 8% by the end
of 1992.
Capital adequacy soon became the main focus of the Committee's activities. In the early 1980s,
the onset of the Latin American debt crisis heightened the Committee's concerns that the capital
ratios of the main international banks were deteriorating at a time of growing international risks.
Backed by the G10 Governors, the Committee members resolved to halt the erosion of capital
standards in their banking systems and to work towards greater convergence in the measurement
of capital adequacy. This resulted in a broad consensus on a weighted approach to the
measurement of risk, both on and off banks' balance sheets.
There was a strong recognition within the Committee of the overriding need for a multinational
accord to strengthen the stability of the international banking system and to remove a source of
competitive inequality arising from differences in national capital requirements. Following
comments on a consultative paper published in December 1987, a capital measurement system
commonly referred to as the Basel Capital Accord (or the 1988 Accord) was approved by the
G10 Governors and released to banks in July 1988.
The Accord called for a minimum capital ratio of capital to risk-weighted assets of 8% to be
implemented by the end of 1992. Ultimately, this framework was introduced not only in member
countries but also in virtually all other countries with active international banks. In September
1993, a statement was issued confirming that all the banks in the G10 countries with material
international banking business were meeting the minimum requirements set out in the 1988
Accord.
The 1988 capital framework was always intended to evolve over time. In November 1991, it was
amended to give greater precision to the definition of general provisions or general loan-loss
reserves that could be included in the capital adequacy calculation. In April 1995, the Committee
issued an amendment to the Capital Accord, to take effect at end-1995, to recognize the effects
11
of bilateral netting of banks' credit exposures in derivative products and to expand the matrix of
add-on factors. In April 1996, another document was issued explaining how Committee members
intended to recognize the effects of multilateral netting.
The Committee also refined the framework to address risks other than credit risk, which was the
focus of the 1988 Accord. In January 1996, following two consultative processes, the Committee
issued the so-called Market Risk Amendment to the Capital Accord to take effect at the end of
1997 at the latest.
This was designed to incorporate within the Accord a capital requirement for the market risks
arising from banks' exposures to foreign exchange, traded debt securities, equities, commodities
and options. An important aspect of this amendment is that banks are allowed to use internal
value-at-risk models as a basis for measuring their market risk capital requirements, subject to
strict quantitative and qualitative standards. Much of the preparatory work for the market risk
package was undertaken jointly with securities regulators.
Basel – II
Basel II retained the ‘pillar’ framework of Basel I, yet crucially expanded the scope and specifics
of Basel I. The 4 pillars were amended as follows:
Minimum Capital Requirements, risks & target adequacy ratio: The primary mandate of
widening the scope of regulation was achieved by expanding the definition of banking
institutions to include them on a fully consolidated basis. Reserves requirement were
defined as follows:
Reserves = 8% * Risk-Weighted Assets + Operational Risk Reserves + Market Risk Reserves
Regulator-Bank Interaction: This empowers regulators in supervision and dissolution of
banks, giving them liberty to set buffer capital requirement above the minimum capital
requirement as per pillar I.
Banking Sector Discipline: It aims to induce discipline by mandating adequate
disclosures about capital and risk profile to the regulators and public.
The new framework was designed to improve the way regulatory capital requirements reflect
underlying risks and to better address the financial innovation that had occurred in recent years.
The changes aimed at rewarding and encouraging continued improvements in risk measurement
and control.
The framework's publication in June 2004 followed almost six years of intensive preparation.
During this period, the Basel Committee had consulted extensively with banking sector
representatives, supervisory agencies, and central banks and outside observers in an attempt to
develop significantly more risk-sensitive capital requirements.
Following the June 2004 release, which focused primarily on the banking book, the Committee
turned its attention to the trading book. In close cooperation with the International Organization
of Securities Commissions (IOSCO), the international body of securities regulators, the
12
Committee published in July 2005 a consensus document governing the treatment of banks'
trading books under the new framework. For ease of reference, this new text was integrated with
the June 2004 text in a comprehensive document released in June 2006.
Both Committee member countries and several non-member countries agreed to adopt the new
rules, albeit on varying timescales. Thus, consistent implementation of the new framework
across borders has become a challenging task for the Committee. To encourage collaboration and
shared approaches, the Committee's Supervision and Implementation Group (SIG) serves as a
forum on implementation matters. The SIG discusses issues of mutual concern with supervisors
outside the Committee's membership through its contacts with regional associations. In January
2009, its mandate was broadened to concentrate on implementation of Basel Committee
guidance and standards more generally.
One challenge that supervisors worldwide faced under Basel II was the need to approve the use
of certain approaches to risk measurement in multiple jurisdictions. While this is not a new
concept for the supervisory community - the Market Risk Amendment of 1996 involved a similar
requirement - Basel II extended the scope of such approvals and demanded an even greater
degree of cooperation between home and host supervisors. To help address this issue, the
Committee issued guidance on information-sharing and supervisory cooperation and allocation
mechanisms in the context of Advanced Measurement Approaches in 2006 and 2007,
respectively.
Basel – III
There were several limitations of Basel II. It was recommended for G-10 counties, thus leaving
out the emerging economies. The scope of responsibilities for regulators in emerging economies
may be too much for them to handle. Central banks might not be stringent enough in regulating
private banks, thus letting them raise their risk exposure – defeating the entire purpose.
The essence of Basel III revolves around compliance regarding capital and liquidity. While good
quality of capital will ensure stable long term sustenance, compliance with liquidity covers will
increase ability to withstand short term economic and financial stress.
Liquidity Rules: The two standards of liquidity are:
Liquidity Coverage Ratio (LCR): This is to safeguard banks against sustained financial
stress for 30 days period.
Net Stable Funding Ratio (NSFR): The objective of long term stability of financial
liquidity risk profile is met by maintaining a ratio of amount available of stable funding
to required amount of stable funding at a minimum of 100%.
Capital Rules: Enhancement of risk coverage is achieved by introduction of Capital
Conservation Buffer and Countercyclical Buffer.
13
Capital Conservation Buffer: A buffer of 2.5% (entirely out of Tier I capital) above
minimum capital requirement to be maintained to ensure that banks accumulate buffers in
time of low financial stress. It discourages distribution of earnings as a signal of financial
strength in times of reduced buffers
Countercyclical Buffer: This buffer can be enacted by national authorities when they
believe that the excess credit growth potentially implies a threat of financial distress.
Leverage Ratio: This aims to avoid the overuse of on- and off-balance sheet leverage in
the banking sector, despite portraying healthy risk based capital ratios, a characteristic of
the 2007 financial crisis.
Even before Lehman Brothers collapsed in September 2008, the need for a fundamental
strengthening of the Basel II framework had become apparent. The banking sector had entered
the crisis with too much leverage and inadequate liquidity buffers. These defects were
accompanied by poor governance and risk management, as well as inappropriate incentive
structures. The combination of these factors was manifest in the mispricing of credit and
liquidity risk, and excess credit growth.
Responding to these risk factors, the Basel Committee issued Principles for sound liquidity risk
management and supervision in the same month that Lehman Brothers failed. In July 2009, the
Committee issued a further package of documents to strengthen the Basel II capital framework,
notably with regard to the treatment of certain complex securitization positions, off-balance sheet
vehicles and trading book exposures. These enhancements were part of a broader effort to
strengthen the regulation and supervision of internationally active banks, in the light of
weaknesses revealed by the financial market crisis.
In September 2010, the Group of Governors and Heads of Supervision announced higher global
minimum capital standards for commercial banks. This followed an agreement reached in July
regarding the overall design of the capital and liquidity reform package, now referred to as
"Basel III". In November 2010, the new capital and liquidity standards were endorsed at the G20
Leaders Summit in Seoul. The Basel Committee has worked in close collaboration with the
Financial Stability Board (FSB) given the FSB's role in coordinating the monitoring of
implementation of regulatory reforms. The Committee designed its programme to be consistent
with the FSB's Coordination Framework for Monitoring the Implementation of Financial
Reforms (CFIM) as agreed by the G20.
These tightened definitions of capital, significantly higher minimum ratios and the introduction
of a macro prudential overlay represent a fundamental overhaul for banking regulation. At the
same time, the Basel Committee, its governing body and the G20 Leaders have emphasized that
the reforms will be introduced in a way that does not impede the recovery of the real economy.
In addition, time is needed to translate the new internationally agreed standards into national
legislation. To reflect these concerns, a set of transitional arrangements for the new standards
was announced as early as September 2010, although national authorities are free to impose
higher standards and shorten transition periods where appropriate.
14
The new, strengthened definition of capital will be phased in over five years: the requirements
were introduced in 2013 and will be fully implemented by the end of 2017. Capital instruments
that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out
over 10 years beginning 1 January 2013.
Turning to the minimum capital requirements, the higher minimums for common equity and Tier
1 capital are being phased in from 2013, and will become effective at the beginning of 2015. The
schedule will be as follows:
The minimum common equity and Tier 1 requirements increased from 2% and 4% levels
to 3.5% and 4.5%, respectively, at the beginning of 2013.
The minimum common equity and Tier 1 requirements will be 4% and 5.5%,
respectively, starting in 2014.
The final requirements for common equity and Tier 1 capital will be 4.5% and 6%,
respectively, beginning in 2015.
The 2.5% capital conservation buffer, which will comprise common equity and is in addition to
the 4.5% minimum requirement, will be phased in progressively starting on 1 January 2016, and
will become fully effective by 1 January 2019.
The leverage ratio will also be phased in gradually. The test (the so-called "parallel run period")
began in 2013 and run until 2017, with a view to migrating to a Pillar 1 treatment on 1 January
2018 based on review and appropriate calibration.
The liquidity coverage ratio (LCR) will be phased in from 1 January 2015 and will require banks
to hold a buffer of high-quality liquid assets sufficient to deal with the cash outflows encountered
in an acute short-term stress scenario as specified by supervisors. To ensure that banks can
implement the LCR without disruption to their financing activities, the minimum LCR
requirement will begin at 60% in 2015, rising in equal annual steps of 10 percentage points to
reach 100% on 1 January 2019.
The other minimum liquidity standard introduced by Basel III is the net stable funding ratio. This
requirement, which will be introduced as a minimum standard by 1 January 2018, will address
funding mismatches and provide incentives for banks to use stable sources to fund their
activities.
Critical Review of BASEL III
The global financial meltdown in 2007-2009 bought to fore the limitations of the Basel II accord.
The norms failed to capture losses on off-balance sheet items leading to a decline in return on
equity, in spite of meeting capital adequacy ratios. The new Basel III accord intends to
proactively plug leakages from the previous norms.
For a country in crisis, it is estimated that, on an average, Basel III will impact by 4.9%, while
the estimates are substantially higher for non-crisis countries. Given the impact regulations on
capital adequacy can potentially have on a country, it is imperative for policy makers to
15
recognize reasons for high elasticity and high cost of equity. Further, it is prudent for the central
bank of a country to consider the capital adequacy norms and requirement of additional capital as
an important tool to regulate monetary policy.
Australia: Australia was largely insulated from the 2007 crisis. Two measures saved Australia in
this regard – the preventive actions taken prior to 2008, and the extraordinary public sector
intervention 2008 onwards.
The key preventive actions in the period prior to 2008 are as follows:
Well-managed Australian Authorized Deposit-taking Institutions (ADIs), which were
prudent to avoid taking on unsustainably risky assets;
Preemptive Australian Prudential Regulation Authority (APRA) supervision, maintaining
an emphasis on capital adequacy and sound asset quality; and
More stringent adoption of Basel II, which actually incorporated several propositions of
Basel III.
It is important to note that tough times could indeed arise as a consequence of economic
reversals in the Australian economy. In such a scenario, Australian ADIs would plausibly face a
far higher level of capital stress. Clearly, the Australian Basel II framework might prove to be
lacking. This is where the Basel III framework comes in – it incorporates a higher quality as well
as quantity of capital.
Brazil: Brazil is expected to implement Basel III norms by October 2013, and will follow the
international schedule as indicated by BCBS, with a few aspects to be implemented by 2012
itself. The requirement of additional capital to comply with Basel III norms is quite low in
Brazil, and hence, is unlikely to have a negative impact on economic growth. The grey line
indicates capital requirement of 11%. Except 3 banks, most of the banks comply with the
regulation. The capital adequacy shall be raised to 13% under Basel III norms, in which case, 9
banks shall have a shortfall, while 18 banks shall be uncomfortably close to the regulation.
However, banks shall have until 2019 to comply. Refer to Exhibit 4 for the timeline of phased
implementation of Basel III accord in Brazil.
United Kingdom: Across the EU, the Basel norms are implemented under the legal name of
Capital Requirements Directives (CRD). In UK, the responsibility of convergence to CRD is
equally shared between the Financial Services Authority (FSA) and the HM Treasury. Following
the 2008 financial turmoil gripping UK, the Prudential Regulation Authority (PRA) was formed
as a successor to Financial Services Authority (FSA), the banking regulator, in April 2013, as a
part of restructuring efforts for more effective supervision and governance. CRD IV, which
directs implementation of Basel III, has been approved by the EU parliament, with the
implementation to commence from January 2014. This creates an obligation to adopt the Basel
III norms on all the member countries including the United Kingdom.
16
United States of America: Banking regulation is highly fragmented in U.S., because of the
existence of regulation at both the federal and state level. The U.S. has always been a laggard in
implementation of Basel norms. Multiple regulatory bodies have interest in the same issue.
All the banks in USA continue to follow the revised Basel I norms. Certain portions of advanced
approach of Basel II were implemented, which applies to the most complex banks. This led to
the Basel II norms being applicable for only large financial institutions, keeping the majority of
the banking community outside the purview.
The financial crisis of 2008 called for sweeping changes in banking supervision and regulation
standards in the country. Stringent capital requirements, severe credit analysis of securities rated
externally and enhancement of Pillar 2 (Supervisory and review process) and Pillar 3 (Disclose
and market discipline) were implemented.
Basel III shall be implemented in USA in a phased manner between January 1, 2013 and January
1, 2019. Implementation of Basel III norms in USA will require an additional Core Tier I Capital
to the extent of $700bn, and total Tier I capital of $870bn, with the gap in long term funding
estimated at $3.2trillion. These shortfalls are expected bring down Return on Equity of banks by
3%.
1.2 INTRODUCTION OF NARSIMHAM COMMITTEE:
From the 1991 India economic crisis to its status of third largest economy in the world by 2011,
India has grown significantly in terms of economic development. So has its banking sector.
During this period, recognizing the evolving needs of the sector, the Finance Ministry of
Government of India (GOI) set up various committees with the task of analyzing India's banking
sector and recommending legislation and regulations to make it more effective, competitive and
efficient. Two such expert Committees were set up under the chairmanship of M. Narasimham.
They submitted their recommendations in the 1990s in reports widely known as the Narasimham
Committee-I (1991) report and the Narasimham Committee-II (1998) Report. These
recommendations not only helped unleash the potential of banking in India, they are also
recognized as a factor towards minimizing the impact of global financial crisis starting in 2007.
Unlike the socialist-democratic era of the 1960s to 1980s, India is no longer insulated from the
global economy and yet its banks survived the 2008 financial crisis relatively unscathed, a feat
due in part to these Narasimham Committees.
During the decades of the 60s and the 70s, India nationalized most of its banks. This culminated
with the balance of payments crisis of the Indian economy where India had to airlift gold to
International Monetary Fund (IMF) to loan money to meet its financial obligations. This event
called into question the previous banking policies of India and triggered the era of economic
liberalization in India in 1991. Given that rigidities and weaknesses had made serious inroads
into the Indian banking system by the late 1980s, the Government of India (GOI), post-crisis,
took several steps to remodel the country's financial system. The banking sector, handling 80%
of the flow of money in the economy, needed serious reforms to make it internationally
reputable, accelerate the pace of reforms and develop it into a constructive usher of an efficient,
vibrant and competitive economy by adequately supporting the country's financial needs. In the
17
light of these requirements, two expert Committees were set up in 1990s under the chairmanship
of M. Narasimham (an ex-RBI (Reserve Bank of India) governor) which are widely credited for
spearheading the financial sector reform in India. The first Narasimhan Committee (Committee
on the Financial System – CFS) was appointed by Manmohan Singh as India's Finance Minister
on 14 August 1991, and the second one (Committee on Banking Sector Reforms) was appointed
by P.Chidambaram as Finance Minister in December 1997. Subsequently, the first one widely
came to be known as the Narasimham Committee-I (1991) and the second one as Narasimham-II
Committee (1998). This article is about the recommendations of the Second Narasimham
Committee, the Committee on Banking Sector Reforms.
The purpose of the Narasimham-I Committee was to study all aspects relating to the structure,
organization, functions and procedures of the financial systems and to recommend improvements
in their efficiency and productivity. The Committee submitted its report to the Finance Minister
in November 1991 which was tabled in Parliament on 17 December 1991.
The Narasimham-II Committee was tasked with the progress review of the implementation of the
banking reforms since 1992 with the aim of further strengthening the financial institutions of
India. It focused on issues like size of banks and capital adequacy ratio among other things. M.
Narasimham, Chairman, submitted the report of the Committee on Banking Sector Reforms
(Committee-II) to the Finance Minister Yashwant Sinha in April 1998. The 1998 report of the
Committee to the GOI made the following major recommendations:
Autonomy in Banking - Greater autonomy was proposed for the public sector banks in order for
them to function with equivalent professionalism as their international counterparts. For this the
panel recommended that recruitment procedures, training and remuneration policies of public
sector banks be brought in line with the best-market-practices of professional bank management.
Secondly, the committee recommended GOI equity in nationalized banks be reduced to 33% for
increased autonomy. It also recommended the RBI relinquish its seats on the board of directors
of these banks. The committee further added that given that the government nominees to the
board of banks are often members of parliament, politicians, bureaucrats, etc., they often
interfere in the day-to-day operations of the bank in the form of the behest-lending. As such the
committee recommended a review of functions of banks boards with a view to make them
responsible for enhancing shareholder value through formulation of corporate strategy and
reduction of government equity. To implement this, criteria for autonomous status was identified
by March 1999 (among other implementation measures) and 17 banks were considered eligible
for autonomy. But some recommendations like reduction in Government's equity to 33%, the
issue of greater professionalism and independence of the board of directors of public sector
banks is still awaiting Government follow-through and implementation.
Reform in the role of RBI - First, the committee recommended that the RBI withdraw from the
91-day treasury bills market and that interbank call money and term money markets be restricted
to banks and primary dealers. Second, the Committee proposed a segregation of the roles of RBI
as a regulator of banks and owner of bank. It observed that "The Reserve Bank as a regulator of
the monetary system should not be the owner of a bank in view of a possible conflict of interest".
As such, it highlighted that RBI's role of effective supervision was not adequate and wanted it to
divest its holdings in banks and financial institutions. Pursuant to the recommendations, the RBI
18
introduced a Liquidity Adjustment Facility (LAF) operated through repo and reverse repos to set
a corridor for money market interest rates. To begin with, in April 1999, an Interim Liquidity
Adjustment Facility (ILAF) was introduced pending further up gradation in technology and
legal/procedural changes to facilitate electronic transfer. As for the second recommendation, the
RBI decided to transfer its respective shareholdings of public banks like State Bank of India
(SBI), National Housing Bank (NHB) and National Bank for Agriculture and Rural
Development (NABARD) to GOI. Subsequently, in 2007–08, GOI decided to acquire entire
stake of RBI in SBI, NHB and NABARD. Of these, the terms of sale for SBI were finalized in
2007–08 themselves.
Stronger banking system - The Committee recommended for merger of large Indian banks to
make them strong enough for supporting international trade. It recommended a three tier banking
structure in India through establishment of three large banks with international presence, eight to
ten national banks and a large number of regional and local banks. This proposal had been
severely criticized by the RBI employees union. The Committee recommended the use of
mergers to build the size and strength of operations for each bank. However, it cautioned that
large banks should merge only with banks of equivalent size and not with weaker banks, which
should be closed down if unable to revitalize themselves. Given the large percentage of non-
performing assets for weaker banks, some as high as 20% of their total assets, the concept of
"narrow banking" was proposed to assist in their rehabilitation. There were a string of mergers in
banks of India during the late 90s and early 2000s, encouraged strongly by the Government of
India GOI in line with the Committee's recommendations. However, the recommended degree of
consolidation is still awaiting sufficient government impetus.
Non-performing assets - Non-performing assets had been the single largest cause of irritation of
the banking sector of India. Earlier the Narasimham Committee-I had broadly concluded that the
main reason for the reduced profitability of the commercial banks in India was the priority sector
lending. The committee had highlighted that 'priority sector lending' was leading to the buildup
of non-performing assets of the banks and thus it recommended it to be phased out.
Subsequently, the Narasimham Committee-II also highlighted the need for 'zero' non-performing
assets for all Indian banks with International presence. The 1998 report further blamed poor
credit decisions, behest-lending and cyclical economic factors among other reasons for the
buildup of the non-performing assets of these banks to uncomfortably high levels. The
Committee recommended creation of Asset Reconstruction Funds or Asset Reconstruction
Companies to take over the bad debts of banks, allowing them to start on a clean-slate. The
option of recapitalization through budgetary provisions was ruled out. Overall the committee
wanted a proper system to identify and classify NPAs, NPAs to be brought down to 3% by 2002
and for an independent loan review mechanism for improved management of loan portfolios.
The committee's recommendations let to introduction of a new legislation which was
subsequently implemented as the Securitization and Reconstruction of Financial Assets and
Enforcement of Security Interest Act, 2002 and came into force with effect from 21 June 2002.
Capital adequacy and tightening of provisioning norms - To improve the inherent strength of
the Indian banking system the committee recommended that the Government should raise the
prescribed capital adequacy norms. This would also improve their risk taking ability; The
committee targeted raising the capital adequacy ratio to 9% by 2000 and 10% by 2002 and have
19
penal provisions for banks that fail to meet these requirements. For asset classification, the
Committee recommended a mandatory 1% in case of standard assets and for the accrual of
interest income to be done every 90 days instead of 180 days. To implement these
recommendations, the RBI in Oct 1998, initiated the second phase of financial sector reforms by
raising the banks' capital adequacy ratio by 1% and tightening the prudential norms for
provisioning and asset classification in a phased manner on the lines of the Narasimham
Committee-II report. The RBI targeted to bring the capital adequacy ratio to 9% by March 2001.
The mid-term Review of the Monetary and Credit Policy of RBI announced another series of
reforms, in line with the recommendations with the Committee, in October 1999.
Entry of foreign bank - The committee suggested that the foreign banks seeking to set up
business in India should have a minimum start-up capital of $25 million as against the existing
requirement of $10 million. It said that foreign banks can be allowed to set up subsidiaries and
joint ventures that should be treated on a par with private banks.
Critical Review of Narsimham Committee
There were protests by employee unions of banks in India against the report. The Union of RBI
employees made a strong protest against the Narasimham II Report. There were other plans by
the United Forum of Bank Unions (UFBU), representing about 1.3 million bank employees in
India, to meet in Delhi and to work out a plan of action in the wake of the Narasimham
Committee report on banking reforms. The committee was also criticized in some quarters as
"anti-poor". According to some, the committees failed to recommend measures for faster
alleviation of poverty in India by generating new employment. This caused some suffering to
small borrowers (both individuals and businesses in tiny, micro and small sectors).
In 1998, RBI Governor Bimal Jalan informed the banks that the RBI had a three to four-year
perspective on the implementation of the Committee's recommendations. Based on the other
recommendations of the committee, the concept of a universal bank was discussed by the RBI
and finally ICICI bank became the first universal bank of India. The RBI published an "Actions
Taken on the Recommendations" report on 31 October 2001 on its own website. Most of the
recommendations of the Committee have been acted upon (as discussed above) although some
major recommendations are still awaiting action from the Government of India.
Initially, the recommendations were well received in all quarters, including the Planning
Commission of India leading to successful implementation of most of its recommendations.
Then it turned out that during the 2008 economic crisis of major economies worldwide,
performance of Indian banking sector was far better than their international counterparts. This
was also credited to the successful implementation of the recommendations of the Narasimham
Committee-II with particular reference to the capital adequacy norms and the recapitalization of
the public sector banks. The impact of the two committees has been so significant that elite
politicians and financial sectors professionals have been discussing these reports for more than a
decade since their first submission applauding their positive contribution.
20
1.3 INTRODUCTION OF RAGHURAM RAJAN COMMITTEE REPORT:
India’s financial system holds one of the keys, if not the key, to the country’s future growth
trajectory. The financial system’s ability to efficiently intermediate domestic and foreign capital
into productive investment and to provide financial services to a vast majority of households will
influence economic as well as social stability.
While India’s financial institutions and regulatory structures have been developing gradually, the
time has come to push forward the next generation of financial reforms. The needs of a growing
and increasingly complex market-oriented economy, and its rising integration with global trade
and finance, call out for deeper, more efficient and well-regulated financial markets.
Notwithstanding concerns about its depth and efficiency, the financial system seems to have
enabled rapid growth and relatively moderate inflation. Arguably, it must be getting something
right. Why fix what ain’t broke? There are three main reasons. First, the financial system is
actually not working well in terms of providing adequate services to the majority of Indians,
meeting the large-scale and sophisticated needs of large Indian corporate, or penetrating deeply
enough to meet the needs of small and medium-sized enterprises. All of this will inevitably
become a barrier to high growth. Second, the financial sector—if unleashed but with proper
regulation--has the potential to generate millions of much-needed jobs and, more important, have
an enormous multiplier effect on economic growth and the inclusiveness of the financial system.
Third, in these uncertain times, financial stability is more important than ever to keep growth
from being derailed by shocks hitting the system, especially from abroad.
Even if one accepts all of this, why now? After all, the world’s deepest and most sophisticated
financial market seems to be imploding, and taking down many foreign financial institutions
with it. Perhaps it is time for India to batten down the hatches, insulate itself from global finance,
and not venture into sophisticated but apparently risky products. This is the wrong lesson to draw
from the U.S. sub-prime mess.
The right lesson is that markets and institutions do succumb occasionally to excesses, which is
why regulators have to be vigilant, constantly striking the right balance between attenuating risk-
taking and inhibiting growth. Similarly, the right lesson to be drawn from the Asian crisis is not
that foreign capital or financial markets are inherently destabilizing, but that weak legal
frameworks and toothless regulation, especially if coupled with public corruption and weak
corporate governance, can spell trouble. Financial sector reforms that lead to well-functioning
competitive markets can reduce these vulnerabilities. Indeed, the U.S. equity, government debt,
and corporate debt markets remain resilient, despite being close to the epicenter of the crisis.
But a robust financial system is not much good if most people don’t have access to it. Financial
inclusion, which means providing not just basic banking but also instruments to insure against
adverse events, is a key priority in India. The absence of access to formal banking services,
which affects more than one-third of poor households, leaves them vulnerable to informal
intermediaries such as moneylenders. Government-imposed priority-sector lending requirements
and interest rate ceilings for small loans have ended up restricting rather than improving broad
access to institutional finance. Banks have no incentive to expand lending if the price of small
loans is fixed by fiat. Consequently, nearly half of the loans taken by those in the bottom quarter
21
of the income distribution are from informal lenders at an interest rate above 36 percent a year,
well above the mandated lending rate. The solution is not more intervention but more
competition between formal and informal financial institutions and fewer strictures on the
former.
With so many difficult challenges, what is the way to proceed? One point to keep in mind is that
many of the reforms are intertwined. For instance, it makes sense to level the playing field
between banks and nonbank financial corporation’s by easing the requirement that the former
finance priority sectors and the government. But making these changes while the government
continues to have huge financing needs and without having a more uniform and nimble
regulatory regime could be dangerous.
The connections, which stretch beyond just financial reforms to broader macroeconomic
reforms, can in fact have a positive effect by reinforcing the effects of individual actions. For
instance, the process of removing restrictions on capital flows could serve as an adjunct to other
reforms if handled adroitly. Allowing foreign investors to participate more freely in corporate
and government debt markets could increase liquidity in those markets, provide financing for
infrastructure investment, and reduce public debt financing through banks.
India’s rich and complex political process being what it is, focusing solely on the big picture
could bog down progress. A hundred small steps, many of them less controversial but still
requiring some resolve on the part of policymakers, could get the process of reforms going and
build up momentum for the bigger challenges that lie ahead. For instance, converting trade
receivable claims to electronic format and creating a structure to allow them to be sold as
commercial paper could greatly boost the credit available to small and medium enterprises.
1.4 INDIAN BANKING SYSTEM:
For decades, banks in India have played an important role in shaping the financial system and
thereby contributing for economic development. This vital role of the banks in India continues
even today albeit the trends in banking delivery has undergone a sea change with the
advancement in usage of information technology as well as design and delivery of customer
service oriented products. Although there has been an extensive mention of existence of banking
in India even during the days of Rig Veda, the comparable banking understandable in terms of
modern banking can be traced to British rule in India during which agency houses carried on the
banking business. The first bank in India – The Hindustan Bank was established in 1779 and
later the General Bank of India was started in 1786. Three more banks namely, the Bank of
Bengal (1809), the Bank of Bombay (1840), and the Bank of Madras (1843) were formed and
were popularly known as “Presidency Banks”. Later in 1920, all the three presidency banks were
amalgamated to form the Imperial Bank of India on 27 January 1921.
The passing of the Reserve Bank of India Act in 1934 and the consequent formation of Reserve
Bank of India (RBI) in 1935 heralded a new era in the Indian banking evolution. Again, with the
passing of the State Bank of India Act in 1955, the undertaking of the Imperial Bank of India
was taken over by State Bank of India (SBI).
22
The Swadeshi movement gave a new dimension to the evolution of banking in India by giving a
fillip to the formation of joint stock banking companies like; The Punjab National Bank Ltd.,
Bank of India Ltd., Canara Bank Ltd., Indian Bank Ltd., the Bank of Baroda Ltd., the Central
Bank of India Ltd., etc. By 1941, there were around 41 Indian banking companies.
Post-Independence period in Indian banking witnessed the emergence of Reserve Bank of India
as India’s central banking authority after it was nationalized and taken over completely by the
Government of India. In 1949, the Banking Regulation Act was enacted which empowered the
Reserve Bank of India (RBI) “to regulate, control, and inspect the banks in India”. Further, the
Indian government decided to nationalize the banks as they failed to heed to the government
directions in enhancing credit to the priority sectors as directed by the government.
Consequently, 14 largest commercial banks nationalized on July 19, 1969. Further, a second
dose of nationalization of 6 more commercial banks followed in 1980. Nationalization of banks
witnessed a rapid expansion of bank branch network in India. Again in 1976, under the Regional
Rural Banks Act, several Regional Rural Banks (RRBs) were set up.
Structure of Indian Banking
India opened up its banking sector in 1991-92 as a part of globalization of Indian economy. The
financial sector reforms initiated by the government could bring in tectonic changes in the
structure and functioning of the commercial banks. Indian Banking structure is broadly made up of
Scheduled and unscheduled banks. Scheduled banks contribute to more than 95 percent of the
banking in India. Scheduled commercial banks include 26 public sector banks (State Bank of India
and its five associates, 19 nationalized banks and IDBI Bank Ltd.), 7 new private sector banks, 14
old private sector banks and 36 foreign banks. The number of SCBs increased to 83 in 2010-11
from 81 in 2009-10. The structure of Indian banking sector is presented in the figure
23
Source: Dr. Swamy “Basel III: Implication on Indian Banking”
As mentioned earlier, RRBs are also scheduled commercial banks with a specific focus and
agenda unlike the commercial banks whose operations are unlimited. RRBs are sponsored by
commercial banks along with the Central Government and the concerned State Governments. As
at the end of March 2011, there were, 82 RRBs functioning in the country (reduced from 196 in
early 2000s on account of restructuring and amalgamation of existing RRBs to improve their
financial soundness). By the end of March 2011, while the assets of RRBs stood at INR 2,15,359
crores (a growth of 17% over the previous year), the deposits were at a level of INR 1,66,232
crores (a 14.6% growth over the previous year). Further, while the advances of RRBs stood at
INR 94,715 crores (a 19.7% growth over previous year), the investments were to the tune of INR
55,280 crores (a growth of 16.9% over the previous year) by the end of March 2011.
There were 97410 cooperatives in the country as at the end of March 2011 amongst which the
Urban Cooperative Banks (UCBs) were 1645 and rural cooperatives were 95765. Amongst the
UCBs only 53 were scheduled and the remaining 1592 were unscheduled ones. In addition,
amongst the rural cooperatives, long-term cooperatives constituted 717 and the short-term
cooperatives were 95048. While the cooperative banks have a long history of their own, due to
various reasons such as; Lack of recognition of cooperatives as economic institutions, structural
diversity across states, design issues, board and management interface and accountability and
24
politicization of cooperatives and control/interference by government, etc., they have been
constrained in attaining their expected performance.
Development Banks are generally termed as all India financial institutions. As at end-March
2011, there were five financial institutions (FIs) under the regulation of the Reserve Bank viz.,
EXIM Bank, NABARD, NHB, SIDBI and IIBI. Of these, four FIs (EXIM Bank, NABARD,
NHB and SIDBI) are under full-fledged regulation and supervision of the Reserve Bank of India.
Operations and Performances of Indian Banking
The Indian banking sector regarded as edifice of the Indian financial sector, though weathered
the stressful consequences of the global financial instability largely, had to traverse through a
challenging macro-economic environment during the post-crisis period. Shadowed by the
financial crisis, the global financial sector was generally turbulent mainly because of the
European sovereign debt crisis, and sluggish growth recovery in the Euro zone as also in the US.
According to RBI (RBI 2011, p 59), the Indian banking sector performed better in 2010-11 over
the previous year despite the challenging operational environment.
The business of SCBs recorded higher growth in 2010- 11 as compared with their performance
during the last few years. Credit deployment has grown at 22.9 per cent and deposits have grown
at 18.3 per cent in 2010- 11 over the previous year. Consequently, the outstanding credit-deposit
ratio of SCBs has increased to 76.5 per cent in 2010-11 as against 73.6 per cent in the previous
year. While the assets of the SCBs stood at INR 71, 83,522 crores, the deposits were to the tune
of INR 56, 16,432 crores and advances outstanding were INR 42, 98,704 crores. Further
investments of SCBs stood at INR 19, 16,053 crores. Indian financial sector’s resilience lies in
the fact that around 70% of it is domestically owned. In addition, about 74% of the assets of the
Indian banking sector are held by the public sector banks. The relatively feeble presence of
foreign banks helped the sector minimize its exposure to the global toxic assets and thereby had a
minimal impact of the devastative global financial crisis. The off-balance sheet exposures of the
Indian banking sector, which declined during the crisis years 2008-09, 2009-10, have witnessed a
growth of 31 per cent in 2010-11. More than 75% of off-balance sheet exposures in 2010-11
constituted forward exchange contracts. Further, the share of foreign banks constituted more than
66% of off-balance sheet exposures during 2010- 11. Despite the growing pressures on margins owing to higher interest rate environment, the return
on assets (ROA) of SCBs improved to 1.10 per cent in 2010-11 from 1.05 per cent in 2009-10.
The capital to risk weighted assets ratio under both Basel I and II frameworks stood at 13.0 per
cent and 14.2 per cent, respectively in 2010-11 as against the required minimum of 9 per cent.
The gross Non-Performing Assets (NPAs) to gross advances ratio declined to 2.25 per cent in
2010-11 from 2.39 per cent in 2009-10, displaying improvement in asset quality of the banking
sector. Although there was some advancement in the penetration of banking services in 2010-11
over the previous year, the extent of financial exclusion continued to be swaging.
Banking sector being an integral part of the economy in ensuring the efficient transmission of the
funds, it has a close relationship with the other macro-economic factors that play a vital part in
the economic development. Despite the downward movement of some of the economic
25
indicators like the imports and exports, the bank credit has continued to show rising trend in
view of the strong domestic demand led growth.
Financial Soundness in Indian Banking
Banking sector is by far the most central part of the financial system in most of the emerging
economies and is, therefore, also the main source of risk for financial stability. Undoubtedly,
financial soundness of banks has a significant sway on the stability of the financial system as a
whole as the banking system constitutes more than 75% of the financial markets in India. The
Indian banking system endured the onslaught of the global financial crisis and a factor that
bolstered the normal functioning of the banking system even in the face of one of the largest
global financial crisis was its robust capital adequacy. Further, the core banking sector indicators
for India like; Capital Adequacy Ratio (CAR), Capital Adequacy Ratio–Tier-1, Gross Non-
Performing Assets (GNPAs) to total loans, Net Non- Performing Assets (NNPAs) to total loans
and Return on Equity (ROE) have experienced downward pressure during the recent recession
period.. On the contrary, liquid assets to total assets ratio has moved upwards indicating the
tendency of the banks to hold cash during the times of recession instead of investing in loans or
investment products.
Core Banking Sector Indicators in India
Source: Dr. Swamy “Basel III: Implication on Indian Banking”
Interest Rates (Benchmark prime lending rate), Money market rate and the discount rates) which
have significant impact on the lending activity showed downward movement in the Indian
banking scenario
26
Interest Rates in India
Source: Dr. Swamy “Basel III: Implication on Indian Banking”
Under Basel II, Capital to Risk-weighted Assets Ratio (CRAR) of Indian banks as at end-March
2009 was at 14.0 per cent, far above the stipulated level of 9 percent (Figure-5.6). This suggests
that Indian banks have successfully managed to meet the increased capital requirement under the
amended framework.
Capital to Risk Weighted Assets Ratio–Bank Group-wise (As at end-March)
Source: Dr. Swamy “Basel III: Implication on Indian Banking”
27
Prudential Regulation in Indian Banking
Prudential regulation mostly characterizes the adoption of best practices as stipulated by Basel
Accord. However, in devising the regulatory framework for banks, RBI has always kept in focus
the financial stability objective. Some of the counter-cyclical regulatory measures that are now
attracting attention worldwide were already in place in India even before the looming of the
crisis
In terms of capital requirements, even though, as per Basel norms the minimum capital adequacy
ratio (CAR) for banks is 8%, the Indian banks are asked by RBI to maintain the ratio at 9%.
Further, the banks are also stipulated to ensure a minimum Tier I capital ratio of 6 % from April
1, 2010. The current average CAR for the SCBs in India is over 13% while the Tier I capital
ratio is about nine percent. Further, Tier I capital is stated as the one that does not include items
such as intangible assets and deferred tax assets that are now sought to be deducted
internationally.
In the terms of liquidity buffers, Indian banks are found to have substantial holding of liquid
assets as they are required to maintain cash reserve ratio (CRR) which is currently 4.75% and
statutory liquidity ratio (SLR) currently 24% - both ratios as a proportion to their ‘net liabilities’.
As such, in case of maintenance of excess of SLR requirements is always available as a source of
liquidity buffer. Moreover, in order to mitigate liquidity risks at short end, RBI had already
issued detailed Asset-Liability Management (ALM) guidelines encompassing liquidity risk
measurement, reporting framework and prudential limits.
In terms of managing the leverage by banks, RBI has been keeping a watch through the
prudential focus on credit-deposit ratio (CD ratio or CDR) and SLR. Moreover, a prudent focus
on CDR encourages the banks to raise deposits for funding credit flow thus minimizing the use
of purchased funds. Further, as the requirement for SLR is to hold unencumbered securities,
banks cannot leverage the minimum SLR portfolio to take on more assets. Accordingly, the
focus on credit deposit ratio and the SLR prescription have both served to limit the degree of
leverage in the Indian banking system.
Securitization of assets by Indian banks has been regulated by RBI under its guidelines issued in
February 2006. Accordingly, the banks (originators) are prohibited from booking profits upfront
at the time of securitization and also the release of credit enhancement during the life of the
credit-enhanced transaction is disallowed. In view of the same, banks were not having any
incentives to resort to unbridled securitization as observed in “originate-to-distribute57” and
“acquire and arbitrage”58 models of securitization as found in many other countries.
In order to contain the short-term liquidity crisis, RBI recognized the possible impact of
excessive inter- connectedness within the banking system, and has stipulated a restriction on
inter-bank liabilities (IBL) to twice the bank’s net worth. In addition, a higher limit up to 3 times
the net worth is allowed only for those banks whose CAR is at least 25% more than the
minimum of 9%. With a view to recognize the impact that restructuring of credit and slower
growth of credit could have on the credit quality of the banks and also considering the necessity
28
to build up provisions when the bank’s earnings are good, RBI has, in December 2009 advised
the banks to maintain a provision coverage ratio of not below 70% by September 2010.
29
CHAPTER 2
RESEARCH
METHODOLOGY
30
2.1 NEED OF THE STUDY:
The topic undertaken for the dissertation is “Impact of BASEL and Other Indian Committees
Recommendation on Indian Banking System”. The purpose behind opting this topic is immense
potential of the Indian banking sector. Half of the population still lives in the villages, which
needs to be included in the financial system for the inclusive growth of the economy and reduce
the NPAs.
In order to improve the banking sector, various committees have been formed such as
Narasimham committee, Raghuram Rajan committee etc for Indian banks. Similarly BASEL
committee had been formed in order to improve the banking sector worldwide by G10 countries.
As it is the era of globalization and liberalization, most of the economies have been linked with
each other. Anything happened in one country has cascading effect on the other countries’
economy. The effect was recently observed in the 2008 market crash and defaulting of various
European countries on their debt obligation (PIGS countries). Any crash or boom has one thing
in common and that plays a key role in order to make it happen. It is the money flow mechanism
of the countries’ banking sector liquidity. A fragile banking industry could not sustain the growth
of the economy for a longer period of time. This can be clearly proved by 2008 crisis, which
leads to the fall of many banking giants which were too large to fall.
2.2 RESEARCH DESIGN AND SURVEY DESIGN:
Research approach would be based on the quantitative & qualitative section. Here, the data and
information gathered would be in moreover in the form of text, comments or numeric value. We
have to screen all the collected data and information and scratch out the required information out
of that. Here, we have to rely on the information, comments or data released/provided by the
designated authorities related to the RBI. The data would be gathered and distributed in form of
text and numeric only and put at the required stages.
Accordingly considered research approaches is essential, as it permits researcher to draw more
conversant information about the selected research design; this information afterward permits the
researcher to acclimatize the research design and furnish for limitations (Easterby- Smith et al
2002) cited by Saunders (2007).
2.3 DATA ANALYSIS:
The Data would be analyzed from the texts, numeric information provided by the experts and
samples. This information would be segregated as per the requirement and the concrete
information will be distributed according to the required heads.
(A) Secondary Data – The data would be collected from the earlier Journals, and data
collected from the designated authorities
The data would be moreover in the form of numeric value of text information, so that has to be
converted into presentable or graphical form as per the requirement of the project.
31
2.4 RESEARCH METHODOLOGY:
(A) Historical research
It creates explanations & sometimes attempted explanations, of conditions, situations and events
that have occurred in near past. For Example, Any research that documents the evolution of
teacher training program since the turn of century, with the focus of defining the historical
origins of the content and processes of current programs (Postlethwaite, 2005)
Here, in this study, this methodology may solve the problem because, the study on Impact of
BASEL and other Indian Committees Recommendations on Indian Banking System.
(B) Descriptive research
It provides information about conditions, situations and events that occur in the current. For
example, a survey of the physical conditions of school building in order to establish a descriptive
profile of the facilities that exist in a typical school. (Postlethwaite, 2005)
This is a very elaborative and correct kind of research method, where we not only rely on the
past trends and studies but also can observe the current studies and current concepts. The study
on study on Impact of BASEL and other Indian Committees Recommendations on Indian
Banking System
(C) Correlation research
It involves the search for relationship between variables through the use of various measures of
statistical association. For example, an investigation of the relationship between teachers’
satisfaction with their job and various factors describing the provision and quality of teacher
housing, salaries, leave entitlements, and the availability of class room supplies. (Postlethwaite,
2005)
Correlation research method makes relationship between two variables. And our study does not
satisfy this methodology because we are studying on only study on Impact of BASEL and other
Indian Committees Recommendations on Indian Banking System. The sector selected is only
RBI Guidelines, i.e., if there would be comparison between two industries then it could be used.
(D) Causal research
It aims to suggest casual linkages between variables by observing existing phenomena and then
searching back through available data in order to try to identify plausible casual relationships.
For example, a study of factors related to student ‘drop out’ from secondary school using data
obtained from school records over the past decade. (Postlethwaite, 2005)
Our study regarding “Impact of BASEL and other Indian Committees Recommendations on
Indian Banking System” does not satisfy this kind of research methodology because, this study is
completely depended on the factual data and theories, and casual method simply solves the
problems which have been already almost solved. It means, this method is suitable when you
already know the results but you simply need any fact to support that.
32
(E) Experimental research
It is used in settings where variables defining one or more “causes” can be manipulated in a
systematic fashion in order to discern “effects’ on other variables. For Example, an investigation
of the effectiveness of two new textbooks using random assignment of teachers and students of
three groups – two groups for each of the new textbooks, and one group as a ‘control’ group to
use the existing textbook. (Postlethwaite, 2005)
Experimental research methodology is suitable where we are completely studying any field or
study which is altogether virgin and has not been touched earlier. And the researcher has to make
various experiments to come out on one result. Here, we are studying a field where, we are
moreover relied on the persons and information which is already existed in this field.
(F) Case study research
It generally refers to two distinct research approaches. The first consist of and in depth of a
particular student, classroom or school with the aim of producing a nuanced description of
pervading cultural setting that affects education, and an account of the interactions that take
place between students and other relevant persons. For example, an in-depth exploration of the
patterns of friendship between students in a single class, the second approach to case study
research involves the application of quantitative research methods to non-probability samples-
which provide results that are not necessarily designed to generalizable to wider populations. For
example, a survey of the reading achievements of the students in one rural region of a particular
country (Postlethwaite, 2005)
Case study research more over focus on the past data and past information, where we study a
case, which is almost similar to our current problem or study so, as such we are not dealing with
such kind of study or case, we are collecting desecrated information from different places and
gathering at one common place to come out on one judgment.
(G) Ethnographic research
It usually consists of a description of events that occur within the life of a group – with particular
reference to the interaction of individuals in the context of socio cultural norms, rituals and
beliefs shared by the group. The researcher generally participates in some part of the normal life
of the group and uses what he or she learns from his participation to understand the interactions
between group members. For example, a detailed account of the daily tasks and interactions
encountered by a school principal using observations gathered by a researcher who is placed in
the position of “Principal’s Assistant’ in order to become fully involved in the daily life of the
school. (Postlethwaite, 2005)
This type of method suffices the kind the research which is not based on data and facts but on the
social and cultural behavior of the people, for example to understand the customers purchasing
behavior etc. So, our study does not suit this method.
(H) Research and development research
It differs from the above types of research in that, rather than bringing new information to light,
it focuses on the interaction between research and the production and evaluation of a new
product. This type of research can be ‘formative’. For example, an investigation of teachers’
33
reactions to the various drafts and redrafts of a new mathematics teaching kit, with the
information gathered at each stage being used to improve each stage of the drafting process.
Alternatively, it can be used summative. For example, a comparison of the mathematics
achievements of student exposed to anew mathematics teaching kit in comparison with students
exposed to the established mathematics curriculum. (Postlethwaite, 2005)
Well, this kind of method itself defines that it is not suitable for our study, which we are doing
on “Impact of BASEL and other Indian Committees Recommendations on Indian Banking
System”.
So, finally, from all the above mentioned research methodology, we reached on the point that,
the current study “Impact of BASEL and other Indian Committees Recommendations on Indian
Banking System” satisfy the Descriptive research method. Because, here we are suppose to deal
with the information and data which is based on the past facts and figures and at the same
moment current judgment and studies.
2.5 RESEARCH DESIGN:
Phase I- Exploratory work
Exploratory information has been collected from the interviews (mentioned in various journals)
of the various senior officials related BASEL & Other committee recommendations in RBI
Journals.
Phase II- Descriptive research
Descriptive study is done from the various journals, websites & from the books of the authors,
who have specifically written about the BASEL & Other committee's recommendations.
Research Type: Descriptive.
2.6 PROJECT OBJECTIVE:
Research on the recommendation of BASEL committees.
Research on the recommendation of Indian banking committees such as Narasimham
committee, Raghuram Rajan committee etc.
Before and after the implementation of these recommendation in the banking industry.
Analysis of the bank’s balance sheet for the improvements after the recommendation.
2.7 EXPECTED OUTCOME:
Better understanding of the banking industry regulation.
Banking structure in India.
Regulatory structure of the banks in Indian and global.
Impact of the committee’s recommendation on Indian banking sector.
Various risks faced by the banks.
Day to day capital requirements by the banks for their smooth operation
34
CHAPTER 3
DATA ANALYSIS
35
3.1 BASEL III:
Basel III guidelines attempt to enhance the ability of banks to withstand periods of economic and
financial stress by prescribing more stringent capital and liquidity requirements for them. The
new Basel III capital requirement would be a positive impact for banks as it raises the minimum
core capital stipulation, introduces counter-cyclical measures, and enhances banks’ ability to
conserve core capital in the event of stress through a conservation capital buffer. The prescribed
liquidity requirements, on the other hand, would bring in uniformity in the liquidity standards
followed by the banks globally. This liquidity standard requirement, would benefit the Indian
banks manage pressure on liquidity in a stress scenario more effectively. Although implementing
Basel III will only be an evolutionary step, the impact of Basel III on the banking sector cannot
be underestimated, as it will drive significant challenges that need to be understood and
addressed. Working out the most cost-effective model for implementation of Basel III will be a
critical issue for Indian banking.
Impact on Financial System - Basel III framework implementation would lead to reduced risk of
systemic banking crises as the enhanced capital and liquidity buffers together lead to better
management of probable risks emanating due to counterparty defaults and or liquidity stress
circumstances. Further, in view of the stricter norms on Inter-bank liability limits, there would be
reduction of the interdependence of the banks and thereby reduced interconnectivity among the
banks would save the banks from contagion risk during the times of crises.
Undoubtedly, Basel III implementation would strengthen the Indian banking sector’s ability to
absorb shocks arising from financial and economic stress, whatever the source be, and
consequently reduce the risk of spillovers from the financial sector to the real economy.
On Weaker Banks- Further, there would be a drastic impact on the weaker banks leading to their
crowding out. As is well established, as conditions deteriorate and the regulatory position gets
even more intensive, the weaker banks would definitely find it very challenging to raise the
required capital and funding. In turn, this would affect their business models apart from tilting
the banking businesses in favor of large financial institutions and thereby tilting the competition.
Increase Supervisory Vigil - Banking operations might experience a reduced pace as there
would be an increased supervisory vigil on the activities of the banks in terms of ensuring the
capital standards, liquidity ratios – LCR and NSFR and others.
Reorganization of Institutions - The increased focus of the regulatory authorities on the
organizational structure and capital structure ability of the financial firms (mainly banks) would
lead the banks to reorganize their legal identity by resorting to mergers & acquisitions and
disposals of portfolios, entities, or parts of entities wherever possible.
International Arbitrage - In case of inconsistent implementation of Basel III framework among
different countries would lead to international arbitrage thereby resulting in disruption of global
financial stability.
36
Capital standards for India - Indian banks need to look for quality capital and also have to
preserve the core capital as well as use it more efficiently in the backdrop of Basel III
implementation. Indian banks look comfortably placed; they will have to phase out those
instruments from their capital that are disallowed under Basel III.
Comparison of Capital Requirement Standards
Minimum Capital Ratios Basel
III of
BCBs
Basel III
of RBI
Existing
RBI
norms
PSBs
Current
Position
Private
Banks
Current
Position
Minimum Common Equity Tier 1
(CET1)
4.5% 5.5% 3.6% 7.3% 11.2%
Capital Conservation Buffer
(CCB)
2.5% 2.5% - - -
Minimum CET1 + CCB 7% 8% 3.5% 7.3% 11.2%
Minimum Tier 1 Capital 7% 7% 3.6% 7.3% 11.2%
Minimum Total Capital Including
Buffer
8% 9% 6% 8.1% 11.5%
Minimum Total Capital + CCB 10.5% 11.5% 9.0% 12.1% 15.9%
Additional Counter Cyclical
Buffer in the form of Common
Equity Capital
0-
2.5%
0-2.5% NA NA NA
Source: RBI Guidelines
Deductions from Capital – Basel III guidelines Vs. Existing RBI norms
Particulars BASEL III of RBI Existing RBI Norms Impact
Limit on deductions
Deductions would be
made if deductibles
exceed the 15% of
core capital at an
aggregate level, or
10% at the individual
item level.
All deductibles to be
deducted
Positive
Deductions from Tier
I or Tier II
All deductions from
core capital
50% of the deductions
from Tier I and
remaining 50% from
Tier II capital
(excepting DTAs and
intangibles where
100% deduction is
made from Tier I
capital
Negative
Treatment of
significant
Aggregated total
equity investment in
For investments upto:
(a) 30%:
Negative
37
investments in
common shares of
unconsolidated
financial
entities
entities where banks
own more than 10%
of shares • (a) Less
than 10% of banks’
common equity – 250
risk
weight (b) More than
10 % will
be deducted from
common
equity
125% risk weight or
risk weight as
warranted by external
rating
(b) 30-50%: 50%
deduction from Tier I
capital and 50% from
Tier II capital
Source: RBI Guidelines
Out of 10.50%, total equity, the capital (equity + reserves) requirement is hiked from the existing
2% to 7%. However, tier II capital that is hybrid capital (fund raising through mostly debt
instruments) dumped from 4% to 2%. Further, with the stipulation of “countercyclical buffer” of
up to 2.5%, the total CAR requirement would raise upto 13%.
Though Indian banks are undoubtedly well capitalized, and maintaining a higher equity capital
ratio than stipulated under Basel III guidelines, they are indeed required to strengthen their
common equity after the relevant deductions. Investor preference would require the banks to
ensure that all the banks would have to maintain an equity capital ratio of higher than 7% by
2013.
CRAR Levels of Indian Banking
Source: Developed by author based on data from RBI Publications
In view of the predicted favorable economic growth over the next three years, it would enable
the banks to shore up their capital bases through issuance of equity. However, a few of the below
38
average performing banks may be necessitated to raise additional equity capital to maintain the
required 7%.
3.2 IMPACT OF BASEL III ON LOAN SPREADS:
The purpose of this section is to map the capital and liquidity requirements as per Basel III to
bank lending spreads. This estimation supposes that the return on equity (ROE) and the cost of
debt are unaffected, with no change in other sources of income and on the same line of thought it
is further assumed that there is no reduction in operating expenses. Such a mapping endows
researchers with a useful instrument to analyze the impact of regulatory changes on the cost of
credit and the real economy. A raise in the interest rate charged on bank loans is believed to
reduce loan demand, all else equal, leading to a drop in investment and output.
This methodology has been employed in the BCBS’s assessment of the long-term economic
impact of the proposed regulatory changes on output (BCBS, 2010, King, 2010). Further, the
benefit of these estimates of changes in bank lending spreads could be found in the using them as
inputs into dynamic stochastic general equilibrium models that have been augmented to include a
micro-founded banking sector such as Goodfriend and McCallum (2007), or as a proxy for
increased financial frictions in macroeconomic models that lack a financial sector. Similar to the
studies by Repullo and Suarez (2004) and Ruthenberg and Landskroner (2008) for Basel II
framework, this mapping exercise attempts to illustrate the potential loan pricing implications for
the banks under the Basel III proposals.
A representative bank is designed to map the changes in the bank’s capital structure and to
understand how the composition of assets has an effect on the different components of net
income using the standard accounting relationships. Even though banks can adjust to the
regulatory reforms in several ways, this study supposes that they seek to pass on any additional
costs by raising the cost of loans to end-customers. It is believed that by computing the change in
net income and shareholder’s equity associated with the regulatory changes, we can compute the
increase in lending spreads required to achieve a given return on equity (ROE).
Of course, this approach is not without limitations. This approach does not formally model the
choices faced by the banks, nor does it offers estimates based on an optimization in a general
equilibrium setting. On other hand, as a substitute, it offers a starting point for understanding the
behavioral response of banks to a regulatory change in a most acceptable practical setting. It
enables and the researchers and the policy makers in determining the impact given a country’s
institutional setting, its banking sector and the elasticity of loan demand.
Though this approach can suggest the potential magnitude of the change in lending spreads,
deciding whether banks would be able to pass on these costs to borrowers is beyond the scope of
this study. Further, this approach focuses on the ‘steady state’ and does not consider the
transition period to the higher regulatory requirements. In the steady state, the supply of bank
credit is considered as exogenous and credit rationing is ignored. It is further implied that banks
price their loans to meet the marginal cost of loan production.
39
As this approach is understandably illustrative and general in nature and could be used to
estimate the impact on lending spreads from a change in bank’s capital structure, assets
composition, risk weighted assets and the corporate tax paid by these banks. Also, as this
approach does not rely much on the availability of very large datasets (which are obviously the
requirement in effective use of statistical methods); it is acceptable particularly for practitioners
for easy comprehension. Another advantage of this approach is that it explains how a given
change can alter the bank’s profitability and indicates to different possible behavioral responses
to the regulations including the unintended consequences. Further, this approach being a bottom-
up, micro-founded one, it offers a useful complement to top-down, structural models where the
modeling of the financial sector is necessarily parsimonious. Although this approach is founded
on several assumptions, all the assumptions are apparent, realistic, and simple and can be
modified to check the sensitivity of the results.
This approach focuses on only two elements of Basel III proposals viz., the first relating to
raising the minimum capital requirement and the second relating to enhanced liquidity
requirement. Firstly, though the previous Basel accords (Basel I and II) specified capital
adequacy rules for minimum capital adequacy ratios, however, they could not absorb the losses
during the recent crisis. In this backdrop, Basel III stipulates higher levels of tangible common
equity. In order to achieve this, banks need to increase their common equity with high- quality
capital. Although this can be achieved by deleveraging banks’ balance sheets by offloading
assets in the near term, but it does not change the fact that the relative share of common equity
and liabilities need to change.
Secondly, as per the Basel III framework, banks are required to meet two new liquidity standard
requirements viz., liquidity coverage ratio (LCR) and net stable funding ratio (NSFR). The LCR
is employed to identify the amount of unencumbered, high quality, liquid assets that can be made
use of to offset cash outflows. Basically, LCR aims to ensure that banks have adequate funding
liquidity to survive at least one month of a situation of stressed funding. As the related data
(requires details on a bank’s expected cash outflows over a one-month period) is not available
for researchers, it cannot be calibrated. The aim of NSFR is to address maturity mismatches
between assets and liabilities. NSFR establishes a minimum adequate amount of stable funding
based on the liquidity characteristics of a bank’s assets over a one-year horizon. This approach
estimates the cost to meet the NSFR. This approach mostly follows the footsteps of King (2010)
in estimating the impact of capital and liquidity requirements on the lending spreads.
This section of the study does not focus on measurement of credit risk, but on the relationships
between a bank’s capital structure, asset composition and their impact on bank’s profitability.
This greater level of detail is vital for understanding as to how the banks respond to the Basel III
regulatory reforms. Both theorists and researchers are quite concerned in understanding these
relationships, albeit they may be too complex to model parsimoniously. By offering greater
detail on the significance of different sources of capital, the present study also contributes to a
growing literature on bank capital structure choices and their impact on lending.
Elliott (2010) is one of the recent studies that has analyzed the loan pricing implications of the
proposed higher capital requirements under Basel III. By providing an accounting-based
analysis, Elliott (2010) has estimated how much the interest rate charged on loans would increase
if banks are required to hold more equity. However, in the stylized model of Elliot, banks hold
40
only loans funded by equity, deposits and wholesale funding and the interest rate on loan is
priced in order to meet a targeted ROE after covering for the cost of liabilities and other fixed
expenses (such as administrative costs and expected loan losses). Using the Federal Deposit
Insurance Corporation (FDIC) data for aggregate United States (US) banking system, Elliott has
calculated that if the ratio of common equity required for a given loan is raised by 2% with no
other changes, banks would need to raise lending spreads by 39 basis points (bps) to maintain the
target ROE of 15%. Further, if the ROE is allowed to fall to 14.5%, lending spread would have
raise only by 9 bps. Elliott summarizes that through a combination of actions the US banking
system would be able to adjust to higher capital requirements and ensure that they would not
have a strong effect on the pricing or availability of bank loans. The merit of the Elliott’s method
is in its simplicity as well as the intuition it provides on pricing of loans and the alternatives
available to banks to adjust to higher capital levels.
The approach of this section of the study is influenced largely by Elliott as well as King’s
approaches. By actual usage of the balance sheet data to compute the regulatory impact, it takes
into account the composition of the assets and liabilities as well the very important distinction
between the assets and risk weighted assets. Further, it models the cost meet the NSFR
unambiguously, elucidating the sensitivity of this computation to the inputs. This study makes an
attempt to compare two steady states, namely, one with and other one without the regulatory
requirements. Firstly, I consider the impact of higher capital requirements in isolation, and then
the cost to meet the NSFR is computed assuming the higher capital requirements have already
been met. Lastly, by considering the potential synergies between the two regulatory
enhancements, it models the capital and liquidity requirements together.
Lending Spreads - A more popular definition for the lending spread is that it is the difference
between the interest rate charged on loans and the rate paid on deposits (Repullo and Suarez,
2004). Goodfriend and McCallum (2007) determine the lending spread as the difference between
the uncollateralized lending rate and the interbank rate. Further, the rate charged by banks on
loans varies on several factors like; terms of the loan, the characteristics of the borrower, the
collateral provided and other costs associated with the loan.
Constructing a representative bank’s financial statements - Stylized balance sheet and income
statement data for scheduled commercial banks in India has been collected from Capitaline Plus
database, respective websites of the banks under study, RBI data- base, and Basel II Pillar III
disclosures of respective banks from their websites. The data employed for analysis is for the
period from 2002 to 2011 as the Capitaline Plus database provides complete datasets only for a
ten-year period IDBI Bank Ltd. in spite of its dual nature, it is also included amongst the public
sector banks. Public sector banks category also includes the State Bank of India and its associate
banks. Private sector banks also include the foreign banks operating in India. Scheduled
commercial banks (SCBs) include both the public and private sector banks.
41
Sample Distribution by Category of Scheduled Commercial Banks in India
Year Public Sector Banks Private Sector Banks SCBs
2002 30 87 117
2003 30 94 124
2004 30 93 123
2005 30 97 127
2006 30 88 118
2007 30 86 116
2008 30 83 113
2009 29 69 98
2010 29 87 116
2011 28 85 113
2014 27 68 95
Source: RBI Guidelines
The number of banks varies by year due to the merger, closure, or entry of a new foreign bank in
the year. Capitaline Plus database does not report RWAs directly in its datasets. Instead the
quantity of RWAs is collected from the more authenticate source; i.e. the Basel II Pillar III
disclosures of respective banks from their websites. Since the Capitaline Plus database presents
the data for category of banks, there was no problem of the outliers and the requirement of
winsorization of capital adequacy ratios to reduce the impact of outliers. Based on the data
described, a representative bank balance sheet and income statement is constructed for each
category of banks by taking the weighted average values for each component of the balance
sheet and the income statement for banks in each category of study. The weights are based on
total assets of the category of the banks.
Stylized Balance sheet and Income Statement of Scheduled Commercial Bank
BALANCE SHEET AVERAGE INCOME STATEMENT AVERAGE
Cash & Balances with RBI 5.59 Interest Income 6.21
Interbank Claims 4.09 Interest Expended 3.97
Investment & Securities 31.48 A. Net Interest Income 2.24
Loans & Advances 53.23 B. Other Income 1.28
Fixed Assets 0.99 C. Total Revenue (A+B) 3.52
Other Assets 4.63 D. Personnel Expenses 0.95
TOTAL ASSETS 100.00 E. Other Administrative Exp 1.37
Deposits by Customer (Retail 75.65 F. Operating Expenses (D+E) 2.32
42
& Corporate)
Interbank Funding Borrowings 9.16 G. Operating Profit (C-F) 1.20
Other Liabilities & Provisions 8.06 H. Tax Provisions 0.36
TOTAL LIABILITIES 92.88 I. Net Income (G-H) 0.84
Capital 1.05
Reserves Total 6.06
Equity Share Warrants 0.00
Equity Application Money 0.00 Return on Equity (ROE %) 0.15
Total Capital 7.12 Leverage Multiple 6.60
TOTAL LIAB & CAPITAL 100.00
Risk Weighted Asset / Total
Asset
65.77 Average Effective Tax Rate
(%)
33.00%
Source: RBI Guidelines
Loans & advances represent about more than half of the typical banks assets, followed by investments & securities (31.48%), cash and balances with RBI (5.59%), other assets (4.63%) and interbank claims (4.09%). These assets are funded mainly by deposits (75.65%), bank borrowings or interbank funding (9.6%). Shareholder’s equity is to the extent of 7.12%. RWAs constitute around 65.77% total assets on average. This ratio is significant when calculating the cost of meeting the higher capital requirement. Table-7.2.2 also shows the consolidated income statement for the representative bank. In terms of the composition of net income, net interest income is 2.24% with non-interest income also important at 1.28%. Total operating expenses constitute 2.32% of total assets. Personnel expenses represent around 41% of total operating expenses. Net income (or ROA) is 0.8%, implying that the average ROE is around 15%. The average historical corporate tax rate is accepted at 33%. 3.3 IMPACT OF BASEL III ON BANK CAPITAL:
Post crisis, on the global there have been sincere efforts towards improving the capital adequacy
of the banks. Capital adequacy levels across banks in most advanced economies were on a rise
between 2008 and 2010. For instance, by 2010, in the US, UK, Germany, and Japan, Capital to
Assets Ratio (CAR) was found to be above 15 per cent. The ratio showed a further increase for
US and German banks in the first quarter of 2011. However, among the major emerging
economies, the level of capital adequacy exhibited a moderate decline between 2009 and 2010,
with the exceptions of China, India, and Mexico. How- ever, Chinese banks experience a modest
decline in their capital positions by March 2011.
Levels of Capital Adequacy Ratios of Banks in Select Economies
Countries 2007 2008 2009 2010 2011 2014
Advanced Economies
France 10.2 10.5 12.4 12.3 …. 12.7
Germany 12.9 13.6 14.8 16.1 16.6 17.3
Greece 11.2 9.4 11.7 11.4 12.3 12.6
Italy 10.4 10.8 12.1 12.3 …. 12.7
Japan 12.3 12.4 15.8 16.7 …. ….
Portugal 10.4 9.4 10.5 10.2 10.5 10.7
Spain 11.4 11.3 12.2 11.8 …. 12.5
43
United Kingdom 12.6 12.9 14.8 15.9 …. 17.1
Unites States 12.8 12.8 14.3 15.3 15.5 ….
Emerging & Developing Economies
Brazil 18.7 18.2 18.9 17.6 18.2 …..
China 8.4 12 11.4 12.2 11.8 …
India 12.3 13 13.2 13.6 …. 14.1
Malaysia 14.4 15.5 18.2 17.5 16.4 16.2
Mexico 15.9 15.3 16.5 16.9 16.5 16.1
Russia 15.5 16.8 20.9 18.1 17.2 17.9 Source:Dr.Swamy“BaselIII:ImplicationonIndianBanking” & http://data.worldbank.org/indicator/FB.BNK.CAPA.ZS
Notwithstanding the progress in CAR, soundness of global banks remained a concern because of
a slow process of deleveraging and increasing levels of NPAs. There has been asymmetry in the
decline in banking sector leverage across countries after the crisis. The percentage of total capital
(and reserves) to total assets has been taken as an indicator of leverage in the banking system.
However, deleveraging has not gained any significant momentum in the banking systems of
other advanced European economies, viz., France, Germany, Portugal, Greece, and Spain,
treating 2008 as the reference point. Further, there was a general weakening of the asset quality
of top global banks. Further, according to RBI, financial soundness of the banking sector is a
sine qua non for the financial system’s stability in a bank-dominated country like India. In the
Indian context, the CAR, however, has weakened in 2010-11 over the previous year mostly due
to a decline in Tier II CAR ratio. Amongst the bank groups, foreign banks have registered the
highest CAR, followed by private sector banks and PSBs in 2010-11. Under Basel II also, the
CAR of SCBs remained well above the required minimum in 2010-11. This implies that, in the
short to medium term, SCBs are not constrained by capital in extending credit.
CRAR Levels of Indian Banking
Source: Dr. Swamy “Basel III: Implication on Indian Banking”
44
According to RBI (RBI 2011), Indian banks can comfortably cope with the proposed Basel III
framework, as they may not face huge difficulty in adjusting to the new capital rules in terms of
both quantum and quality. Quick estimates of RBI (based on the data furnished by banks in their
off-site returns) observe that the CAR of Indian banks under Basel III will be 11.7 per cent (as on
June 30, 2010) as compared with the required CAR under proposed Basel III at 10.5 per cent.
Capital Requirement Standards in Indian Context
Indian banks need to look for quality capital and also have to preserve the core capital as well as
use it more efficiently in the backdrop of Basel III implementation. Out of 10.50%, total equity,
the capital (equity + reserves) requirement has been hiked from the existing 2% to 7%. However,
Tier II capital that is hybrid capital (fund raising through mostly debt instruments) dumped from
4% to 2%. Further, with the stipulation of “counter-cyclical buffer” of up to 2.5%, the total CAR
requirement would raise upto 13%.
Comparison of Capital Requirement Standards
Minimum Capital Ratios Basel
III of
BCBs
Basel III
of RBI
Existing
RBI
norms
PSBs
Current
Position
Private
Banks
Current
Position
Minimum Common Equity Tier 1
(CET1)
4.5% 5.5% 3.6% 7.3% 11.2%
Capital Conservation Buffer
(CCB)
2.5% 2.5% - - -
Minimum CET1 + CCB 7% 8% 3.5% 7.3% 11.2%
Minimum Tier 1 Capital 7% 7% 3.6% 7.3% 11.2%
Minimum Total Capital Including
Buffer
8% 9% 6% 8.1% 11.5%
Minimum Total Capital + CCB 10.5% 11.5% 9.0% 12.1% 15.9%
Additional Counter Cyclical
Buffer in the form of Common
Equity Capital
0-
2.5%
0-2.5% NA NA NA
Source: Dr. Swamy “Basel III: Implication on Indian Banking”
Indian banks look comfortably placed. They will have to phase out those instruments from their
capital that are disallowed under Basel III.
Deductions from Capital – Basel III guidelines Vs. Existing RBI norms
Particulars BASEL III of RBI Existing RBI Norms Impact
Limit on deductions
Deductions would be
made if deductibles
exceed the 15% of
core capital at an
aggregate level, or
10% at the individual
item level.
All deductibles to be
deducted
Positive
45
Deductions from Tier
I or Tier II
All deductions from
core capital
50% of the deductions
from Tier I and
remaining 50% from
Tier II capital
(excepting DTAs and
intangibles where
100% deduction is
made from Tier I
capital
Negative
Treatment of
significant
investments in
common shares of
unconsolidated
financial
entities
Aggregated total
equity investment in
entities where banks
own more than 10%
of shares • (a) Less
than 10% of banks’
common equity – 250
risk
weight (b) More than
10 % will
be deducted from
common
equity
For investments upto:
(a) 30%:
125% risk weight or
risk weight as
warranted by external
rating
(b) 30-50%: 50%
deduction from Tier I
capital and 50% from
Tier II capital
Negative
Source: Dr. Swamy “Basel III: Implication on Indian Banking”
Dynamics of the Likely Impact on Bank Capital
The move to Basel III would enhance the need for capital based on the computation of risk-
weighted assets. In the current Indian banking context, risk- weighted assets are computed based
on standardized approaches. The shift from standardized approaches to risk-based approaches
would enable the Indian banks to rationalize the utilization of risk capital. Under credit risk,
transition from standardized approaches to foundation level internal-risk based approaches can
reduce the capital requirements considerably.
According to (BCBS, 2010), operational risk capital for non-AMA banks is higher than for AMA
banks, regard- less of the exposure indicator used for scaling. As such, under operation risk,
transition to advanced measurement approaches (AMA) is likely to increase the requirement of
market risk capital. Further, the introduction of incremental risk charge for credit risk in the
trading book and stressed VaR is expected to further increase risk-capital requirements.
Exposing the avail- able-for-sale (AFS) portfolio to market risk will further increase the
requirement for capital. Accordingly, transition towards advanced approaches to credit and
operational risk is expected to moderate capital requirements. However, there it is essential to
restructure market risk portfolios in line with the return on capital (RoC) deployed.
46
The new capital requirements as suggested under Basel III is a positive move for Indian banks as
it raises the core capital in the form of common equity, brings in the conservation and counter-
cyclical measures which in order to enable banks to conserve core capital in event of loss.
Though Indian banks are undoubtedly well capitalized, and maintaining a higher equity capital
ratio than stipulated under Basel III guidelines, they are indeed required to strengthen their
common equity after the relevant deductions. Investor preference would require the banks to
ensure that all the banks would have to maintain an equity capital ratio of higher than 7% by
2013.
Impact of Capital Standards
Basel III capital standards framework has indeed greatly revolutionized the capital structure of
banks putting onus on the banks to significantly raise their common equity, common equity,
additional Tier-I capital and Tier-II impact of the key factors of the Basel III regulations on
capital.
Impact of Key factors of capital standards on Equity tiers
Key Factors Impact on
Common
Equity
Capital
Impact on
Additional
Tier-I
Impact on
Additional
Tier-II
Increase in credit deployment Increase Increase Increase
Definition of common equity to exclude share
premium resulting from non-common equity
capital
Increase Decrease NA
Deductions made from common equity
instead of Tier 1 capital
Increase NA NA
Introduction of capital buffer Increase Increase Increase
Increase in capital requirements Increase Increase Increase
Transition to advanced approaches of credit
risk
Decrease Decrease Decrease
Transition to advanced approaches of
operation risk
Decrease Decrease Decrease
Transition to advanced measurement
approaches for measuring market risk
Increase --- ----
Source: Dr. Swamy “Basel III: Implication on Indian Banking”
Possible impact of capital standards on Indian banks
Key Recommendations of BASEL III Possible Impact
Increased quality of capital
May lead to capital raising by banks besides
retention of profits and resorting to reduced
Dividends
Increased quantity of capital
Banks will face additional capital requirement
and hence would raise common equity or
otherwise retain dividends
47
Reduced leverage ratio
This could lead to reduced lending apart from
banks be- coming very choosy in financing the
projects. Banks may reduce credit exposure
and potential credit losses through stricter
credit approval processes and, potentially
through lower limits, especially with regard to
bank exposures. Banks may focus on higher-
risk/higher return lending Pressure arises on
banks to sell low margin
assets
Source: Dr. Swamy “Basel III: Implication on Indian Banking”
BASEL III: Capital Projections for Indian Banks
In the wake of the new Basel III regime in the Indian context, it is attempted in this section of the
study to estimate the required additional minimum Tier-1 capital for the banks. This would
enable the banks to plan their capital raising activity in tune with regulatory requirements. This
exercise is carried out based on the data sourced from Capitaline plus database. As such, these
estimates at the best can be termed as approximations as these have data limitations with regard
to details required in the estimation process.
The methodology adopted includes the estimation process based on the reported Tier-1, Tier-2
capital, total capital and RWAs sourced from the Basel disclosures made by the banks in their
websites. The data for all the scheduled commercial banks has been collected accordingly and
grouped based on the bank groups namely; public sector banks and private banks. The important
assumption made in the estimation process is that RWAs of these banks grow by 10 percentage
points annually in Scenario-1 and 12% per annum in scenario-2 and 15% in Scenario-3. This
increase in RWAs is considered because of the reasoning that the banks grow their loan book
size approximately in the range of 20-25% and also considering the past trend of RWAs.
The estimates are presented in the tables here below. With an assumed growth of RWAs at 10%,
banks in India would require additional minimum tier-1 capital of INR 2,51,106.57 Crores. With
RWAs growth at 12% and 15%, the requirement would be in the order of INR 336390.41 crores
and INR 474168.60 crores respectively.
BASEL III Compliance – Required Minimum Capital
By Year PSBs Private Bank Total
Scenario – 1 with 10% growth in RWAs
2013 6173.54 0.00 6173.54
2014 16206.69 0.00 16206.69
2015 62103.88 2254.28 64358.16
2016 82070.48 5158.26 87228.74
2017 137120.89 13263.44 150384.33
2018 214104.12 37002.44 251106.57
Scenario – 2 with 12% growth in RWAs
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2013 7188.12 0.00 7188.12
2014 30403.23 5.48 30408.72
2015 75469.86 4694.77 80164.63
2016 119891.65 10265.87 130157.51
2017 184195.79 30028.58 214224.37
2018 274793.18 61597.23 336390.41
Scenario – 3 with 15% growth in RWAs
2013 7049.99 0.00 7049.99
2014 110613.04 1099.52 111712.56
2015 117188.41 8601.80 125790.21
2016 170369.71 22517.34 192887.06
2017 256646.88 51563.57 308210.45
2018 378891.07 95277.53 474168.60 Source: Dr. Swamy “Basel III: Implication on Indian Banking”
A study by rating agency Fitch estimates the additional capital requirements at about INR 2.5
lakh crores to 2.75 lakh crores for Indian banks. Moody’s Indian subsidiary ICRA said banks in
the country would re- quire equity capital ranging from Rs 3.9 lakh crores to Rs 5 lakh crores to
comply with Basel III standards. According to global research firm Macquarie, Indian banks
would have to go on a massive capital rising to the extent of over USD 30 billion (INR 1.67 lakh
crores) over the next five years to cater to their growth requirements and Basel-III
implementation charges. Similarly, according to the CARE study too banks have to raise equity
in the range of $45-55 bn to meet BASEL III core equity norms. According to CRISIL, Indian
banks may have to raise a total of about Rs 2.4 trillion to meet growth needs in compliance with
the Reserve Bank of India’s final guidelines on capital adequacy requirements under the new
Basel III norms by March 2018. Although the BASEL III regulations may not put immediate
stress on Indian banks to augment capital, an upsurge in credit off-take and market risk portfolios
is expected to give rise to an increase in the requirement of common equity.
3.4 NARSIMHAM COMMITTEE & ACTION TAKEN:
Measures to Strengthen the Banking System & Capital
The Committee suggests that pending the emergence of markets in India where market
risks can be covered, it would be desirable that capital adequacy requirements take into
account market risks in addition to the credit risks.
Action Taken - Banks are now required to assign capital for market risk. A risk weight of 2.5%
for market risk has been introduced on investments in Govt. and other approved securities with
effect from the year ending 31st March, 2000. For investments in securities outside SLR, a risk
weight of 2.5% for market risk has been introduced with effect from the year ending 31st March,
2001.
In the next three years, the entire portfolio of Government securities should be marked to
market and this schedule of adjustment should be announced at the earliest. It would be
appropriate that there should be a 5% weight for market risk for Govt. and approved
securities.
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Action Taken - The percentage of banks’ portfolio of Govt. and approved securities which is
required to be marked to market has progressively been increased. For the year ending 31st
March, 2000, banks were required to mark to market 75% of their investments. In order to align
the Indian accounting standards with the international best practices and taking into
consideration the evolving international developments, the norms for classification and valuation
of investments have been modified with effect from September 30, 2000. The entire investment
portfolio of banks is required to be classified under three categories, viz., Held to Maturity,
Available for Sale and Held for Trading. While the securities ‘Held for Trading’ and ‘Available
for Sale’ should be marked to market periodically, the securities ‘Held to Maturity’, which
should not exceed 25% of total investments are carried at acquisition cost unless it is more than
the face value, in which case, the premium should be amortized over a period of time.
The risk weight for a Government guaranteed advance should be the same as for other
advances. To ensure that banks do not suddenly face difficulties in meeting the capital
adequacy requirement, the new prescription on risk weight for Government guaranteed
advances should be made prospective from the time the new prescription is put in place.
Action Taken - In cases of Govt. guaranteed advances, where the guarantee has been invoked
and the concerned State Govt. has remained in default as on March 31, 2000, a risk weight of
20% on such advances, has been introduced. State Govts, Who continue to be in default in
respect of such invoked guarantees even after March 31, 2001, a risk weight of 100%, is being
assigned.
There is an additional capital requirement of 5% of the foreign exchange open position
limit. Such risks should be integrated into the calculation of risk weighted assets. The
Committee recommends that the foreign exchange open position limits should carry a
100% risk weight.
Action Taken - Risk weight of 100% has been introduced for foreign exchange open position
limits with effect from March 31, 1999.
The Committee believes that it would be appropriate to go beyond the earlier norms and
set new and higher norms for capital adequacy. The Committee accordingly recommends
that the minimum capital to risk assets ratio be increased to 10% from its present level of
8%. It would be appropriate to phase the increase as was done on the previous occasion.
Accordingly, the Committee recommends that an intermediate minimum target of 9% be
achieved by the year 2000 and the ratio of 10% by 2002. The RBI should also have the
authority to raise this further in respect of individual banks if in its judgments the
situation with respect to their risk profile warrants such an increase. The issue of
individual banks' shortfalls in the CRAR needs to be addressed in much the same way
that the discipline of reserve requirements is now applied, viz., of uniformity across weak
and strong banks.
Action Taken - The minimum capital to risk asset ratio (CRAR) for banks has been enhanced to
9% with effect from the year ending March 31, 2000.
In respect of PSBs, the additional capital requirement will have to come from either the
Govt. or the market. With the many demands on the budget and the continuing imperative
need for fiscal consolidation, subscription to bank capital funds cannot be regarded as a
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priority claim on budgetary resources. Those banks which are in a position to access the
capital market at home or abroad should, therefore, be encouraged to do so.
Action Taken - Banks are permitted to access the capital market. Till today, 12 banks have
already accessed capital market.
Asset Quality, NPAs and Directed Credit
The Committee recommends that an asset be classified as doubtful if it is in the
substandard category for 18 months in the first instance and eventually for 12 months and
loss if it has been so identified but not written off. These norms, which should be
regarded as the minimum, may be brought into force in a phased manner.
Action Taken - Banks have been advised that an asset will be classified as ‘doubtful’ if it has
remained in the substandard category for 18 months instead of 24 months as at present, by March
31, 2001. Banks have been permitted to achieve these norms for additional provisioning in
phases, as under : As on 31.3.2001 Provisioning of not less than 50% on the assets which have
become doubtful on account of the new norm. As on 31.3.2002 Balance of the provisions not
made during the previous year, in addition to the provisions needed as on 31.3.2002.
The Committee has noted that NPA figures do not include advances covered by
Government guarantees which have turned sticky and which in the absence of such
guarantees would have been classified as NPAs. The Committee is of the view that for
the purposes of evaluating the quality of asset portfolio such advances should be treated
as NPAs. If , however, for reason of the sovereign guarantee argument such advances are
excluded from computation, the Committee would recommend that Government
guaranteed advances which otherwise would have been classified as NPAs should be
separately shown as an aspect of fuller disclosure and greater transparency of operations.
Action Taken - Prudential norms in respect of advances guaranteed by State Governments where
guarantee has been invoked and has remained in default for more than two quarters has been
introduced in respect of advances sanctioned against State Government guarantee with effect
from April 1, 2000. Banks have been advised to make provisions for advances guaranteed by
State Governments which stood invoked as on March 31, 2000, in phases, during the financial
years ending March 31, 2000 to March 31, 2003 with a minimum of 25% each year.
Banks and financial institutions should avoid the practice of "ever greening" by making
fresh advances to their troubled constituents only with a view to settling interest dues and
avoiding classification of the loans in question as NPAs. The Committee notes that the
regulatory and supervisory authorities are paying particular attention to such breaches in
the adherence to the spirit of the NPA definitions and are taking appropriate corrective
action. At the same time, it is necessary to resist the suggestions made from time to time
for a relaxation of the definition of NPAs and the norms in this regard.
Action Taken - The RBI has reiterated that banks and financial institutions should adhere to the
prudential norms on asset classification, provisioning, etc. and avoid the practice of “ever
greening”.
The Committee believes that the objective should be to reduce the average level of net
NPAs for all banks to below 5% by the year 2000 and to 3% by 2002. For those banks
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with an international presence the minimum objective should be to reduce gross NPAs to
5% and 3% by the year 2000 and 2002, respectively, and net NPAs to 3% and 0% by
these dates. These targets cannot be achieved in the absence of measures to tackle the
problem of backlog of NPAs on a one time basis and the implementation of strict
prudential norms and management efficiency to prevent the recurrence of this problem.
Action Taken - This is the long-term objective which RBI wants to pursue. Towards this
direction, a number of measures have been taken to arrest the growth of NPAs: banks have been
advised to tone up their credit risk management systems; put in place a loan review mechanism
to ensure that advances, particularly large advances are monitored on an on-going basis so that
signals of weaknesses are detected and corrective action taken early; enhance credit appraisal
skills of their staff, etc. In order to ensure recovery of the stock of NPAs, guidelines for one-time
settlement have been issued in July, 2000.
The Committee is of the firm view that in any effort at financial restructuring in the form
of hiving off the NPA portfolio from the books of the banks or measures to mitigate the
impact of a high level of NPAs must go hand in hand with operational restructuring.
Cleaning up the balance sheets of banks would thus make sense only if simultaneously
steps were taken to prevent or limit the re-emergence of new NPAs which could only
come about through a strict application of prudential norms and managerial improvement.
Action Taken - Banks have been advised to take effective steps for reduction of NPAs and also
put in place risk management systems and practices to prevent re-emergence of fresh NPAs.
For banks with a high NPA portfolio, the Committee suggests consideration of two
alternative approaches to the problem as an alternative to the ARF proposal made by the
earlier CFS. In the first approach, all loan assets in the doubtful and loss categories,
which in any case represent bulk of the hard core NPAs in most banks, should be
identified and their realizable value determined. These assets could be transferred to an
Asset Reconstruction Company (ARC) which would issue to the banks NPA Swap Bonds
representing the realizable value of the assets transferred, provided the stamp duties are
not excessive. The ARC could be set up by one bank or a set of banks or even in the
private sector. In case the banks themselves decide to set up an ARC, it would need to be
ensured that the staff required by the ARC is made available to it by the banks concerned
either on transfer or on deputation basis, so that staff with institutional memory on NPAs
is available to ARC and there is also some rationalization of staff in the banks whose
assets are sought to be transferred to the ARC. Funding of such an ARC could be
facilitated by treating it on par with venture capital for purpose of tax incentives. Some
other banks may be willing to fund such assets in effect by securitizing them. This
approach would be worthwhile and workable if stamp duty rates are minimal and tax
incentives are provided to the banks.
Action Taken - The proposal to set up an Asset Reconstruction Company (ARC) on a pilot basis
to take over the NPAs of the three weak public sector banks, has been announced in the Union
Budget for 1999 – 2000. The modalities for setting up the ARC are being examined.
An alternative approach could be to enable the banks in difficulty to issue bonds which
could form part of Tier II capital. This will help the banks to bolster capital adequacy
which has been eroded because of the provisioning requirements for NPAs. As the banks
52
in difficulty may find it difficult to attract subscribers to bonds. Government will need to
guarantee these instruments which would then make them eligible for SLR investments
by banks and approve instruments by LIC, GIC and Provident Funds.
Action Taken - Banks are permitted to issue bonds for augmenting their Tier II capital.
Guarantee of the Govt. for these bonds is not considered necessary.
Directed credit has a proportionately higher share in NPA portfolio of banks and has been
one of the factors in erosion in the quality of bank assets. There is continuing need for
banks to extend credit to agriculture and small scale sector which are important segments
of the national economy, on commercial considerations and on the basis of
creditworthiness. In this process, there is scope for correcting the distortions arising out
of directed credit and its impact on banks’ assets quality.
Action Taken - The loans to agricultural and SSI sectors are now generally being granted on
commercial considerations and on the basis of creditworthiness of the borrower. Further, the
concessionality on interest rates for advances has been done away with, except for advances
under the DRI Scheme. While advances upto Rs.2 lakh should carry interest rate not exceeding
PLR, interest rates on advances of over Rs.2 lakh have been freed.
The Committee has noted the reasons why the Government could not accept the
recommendation for reducing the scope of directed credit under priority sector from 40%
to 10%. The Committee recognizes that the small and marginal farmers and the tiny
sector of industry and small businesses have problems with regard to obtaining credit and
some earmarking may be necessary for this sector. Under the present dispensation, within
the priority sector 10% of net bank credit is earmarked for lending to weaker sections. A
major portion of this lending is on account of Government sponsored poverty alleviation
and employment generation schemes. The Committee recommends that given the special
needs of this sector, the current practice may continue. The Branch Managers of banks
should, however, be fully responsible for the identification of beneficiaries under the
Government sponsored credit linked schemes. The Committee proposes that given the
importance and needs of employment oriented sectors like food processing and related
service activities in agriculture, fisheries, poultry and dairying, these sectors should also
be covered under the scope of priority sector lending. The Committee recommends that
the interest subsidy element in credit for the priority sector should be totally eliminated
and even interest rates on loans under Rs.2 lakh should be deregulated for scheduled
commercial banks as has been done in the case of Regional Rural Banks and co-operative
credit institutions. The Committee believes that it is the timely and adequate availability
of credit rather than its cost which is material for the intended beneficiaries. The
reduction of the preempted portion of banks' resources through the SLR and CRR would,
in any case, enlarge the ability of banks to dispense credit to these sectors.
Action Taken - As per the present stipulation, banks are required to lend 10% of net bank credit
(NBC) for weaker sections which includes all small and marginal farmers, all IRDP and DRI
borrowers, borrowers under SUME etc. The Committee has recommended that the present
stipulation may continue. As recommended by the Committee, some activities like food
processing, related service activities in agriculture, fisheries, poultry, dairying have been brought
under priority sector. Under the existing dispensation, Units in sectors like food processing, etc.,
satisfying either the definition of SSI [the ceiling of investment in plant and machinery (original
53
cost) for a unit being classified under this category has since been enhanced to Rs. 3 crore from
Rs.60 lakhs / Rs.75 laks for ancillaries and export oriented units] or small business are already
covered under priority sector. No further changes are considered necessary, as larger units need
not be given any advantage by enlarging the scope of definition of priority sector advances. As a
first step towards deregulation of interest rates on credit limits up to R.2 lakh and eliminating
interest subsidy element in credit for priority sector, in the Monetary and Credit Policy
announced in April, 1998, it has been stipulated that interest rates on loans up to Rs.2 lakh
should not exceed PLR as against the earlier stipulation of ‘not exceeding 13.5%’, for credit
limits of Rs.25, 000--Rs.2 lakh and 12% for credit limit up to Rs.25,000. Banks are free to decide
their PLR subject to their obtaining the prior approval of their Boards therefore. As the PLR
differs from bank to bank, depending on their cost of funds and competitive strategies, the
measure is a step towards deregulation of interest rates. Thus the recommendation of the
Committee has been implemented in spirit. It may be stated that except for loans under DRI there
is no subsidization of interest.
Prudential Norms and Disclosure Requirements
With regard to income recognition, in India, income stops accruing when interest or
installment of principal is not paid within 180 days. The Committee believes that we
should move towards international practices in this regard and recommends the
introduction of the norm of 90 days in a phased manner by the year 2002.
Action Taken - The recommendation of the Committee that we should move towards
international practices in regard to income recognition is accepted in principle. However,
tightening of the prudential norms should be made keeping in view the existing legal framework,
production and payment cycles, business practices, the predominant share of agriculture in the
country’s economy, etc. The production and repayment cycles in the industry in the country
generally involve a period of not less than from 4 to 6 months. A large number of SSIs also have
difficulties in timely realization of their bills drawn on the suppliers. These have to be taken into
account while contemplating any change in the norm. Implementation of the recommendation
would have serious implications on the asset portfolio of banks and even good quality borrowers
and find it difficult to comply with the norms recommended. There have been representations
from banks and financial institutions seeking relaxations in the above instructions by increasing
the period to 3-4 quarters. Keeping in view the current industrial scenario, implementation of the
recommendation would have serious implications even to healthy borrowers. Furthermore,
interest on advances is calculated by banks at quarterly rests, keeping in view the large number
and volume of accounts, if we have to implement the recommendation.
At present, there is no requirement in India for a general provision on standard assets. In
the Committee’s view a general provision, say, of 1% would be appropriate and RBI
should consider its introduction in a phased manner.
Action Taken - To start with, a general provision on standard assets of a minimum of 0.25%
from the year ended March 31, 2000 introduced.
There is a need for disclosure, in a phased manner, of the maturity pattern of assets and
liabilities, foreign currency assets and liabilities, movements in provision account and
NPAs. The RBI should direct banks to publish, in addition to financial statements of
independent entities, a consolidated balance sheet to reveal the strength of the group. Full
54
disclosure would also be required of connected lending and lending to sensitive sectors.
Furthermore, it should also ask banks to disclose loans given to related companies in the
bank's balance sheets. Full disclosure of information should not be only a regulatory
requirement. It would be necessary to enable a bank’s creditors, investors and rating
agencies to get a true picture of its functioning – an important requirement in a market
driven financial sector.
Action Taken - Banks have been advised to disclose the following information, in addition to the
existing disclosures, in the ‘Notes on Accounts’ to the balance sheet from the accounting year
ended March 31, 2000.
Maturity pattern of loans and advances,
Maturity pattern of investment securities,
Foreign currency assets and liabilities
Movement in NPAs,
Maturity pattern of deposits
Maturity pattern of borrowings
Lending to sensitive sectors as defined from time to time
Banks should also pay greater attention to asset liability management to avoid
mismatches and to cover, among others, liquidity and interest rate risks.
Action Taken - Detailed guidelines issued to banks on asset –liability management.
Implementation of these guidelines would enable banks to avoid liquidity mismatches as also to
cover, among others, liquidity and interest rate risks.
Banks should be encouraged to adopt statistical risk management techniques like Value-
at-Risk in respect of balance sheet items which are susceptible to market price
fluctuations, forex rate volatility and interest rate changes. While the Reserve Bank may
initially, prescribe certain normative models for market risk management, the ultimate
objective should be that of banks building up their own models and RBI backtesting them
for their validity on a periodical basis.
Action Taken - Comprehensive guidelines have been issued to enable banks to put in place
appropriate risk management systems. Banks have also been advised to adopt statistical risk
management techniques like Value-at-Risk (which is a statistical method of assessing the
potential maximum loss from a credit or investment exposure, over a definite holding period at a
given confidence level) or other models appropriate to their level of business operation.
Systems and Methods in Banks
Banks should bring out revised Operational Manuals and update them regularly, keeping
in view the emerging needs and ensure adherence to the instructions so that these
operations are conducted in the best interest of a bank and with a view to promoting good
customer service. These should form the basic objective of internal control systems, the
major components of which are: (I) Internal Inspection and Audit, including concurrent
audit, (2) Submission of Control Returns by branches/controlling offices to higher level
offices (3) Visits by controlling officials to the field level offices (4) Risk management
systems (5) Simplification of documentation, procedure and of inter office
communication channels.
55
Action Taken - Banks have been advised to bring out revised Operative Manuals and update
them regularly. Banks have confirmed having brought out revised Manuals.
An area requiring close scrutiny in the coming years would be computer audit, in view of
large scale usage and reliance on information technology.
Action Taken - Banks have been advised to set up EDP Audit Cell, as part of their Inspection
Department.
There is enough international experience to show the dangers to an institution arising out
of inadequate reporting to and checking by the back offices of trading transactions and
positions taken. Banks should pay special attention to this aspect.
Action Taken - RBI had in 1992 emphasized to banks the importance of an effective
management reporting system, segregation of the trading and back office functions, etc. The
efficacy of the systems put in place by banks is being constantly reviewed by the RBI through
periodical inspections.
There is need to institute an independent loan review mechanism especially for large
borrowal accounts and systems to identify potential NPAs. It would be desirable that
banks evolve a filtering mechanism by stipulating in-house prudential limits beyond
which exposures on single/group borrowers are taken keeping in view their risk profile as
revealed through credit rating and other relevant factors. Further, in-house limits could be
thought of to limit the concentration of large exposures and industry/sector/geographical
exposures within the Board approved exposure limits and proper overseeing of these by
the senior management/ boards.
Action Taken - Banks have been advised to put in place an independent Loan Review
Mechanism, as recommended by the Committee.
The Committee feels that the present practice of RBI selection of statutory auditors for
banks with Board of Directors having no role in the appointment process, is not
conducive to sound corporate governance. We would recommend that the RBI may
review the existing practice in this regard. It may also reassess the role and function of
the Standing Advisory Committee on Bank Audit in the light of the setting up of the
Audit Committee under the aegis of the Board for Financial Supervision.
Action Taken - The recommendation was put up before the Audit Sub-Committee of the Board
for Financial Supervision which was of the view that the existing practice should continue.
The Committee notes that public sector banks and financial institutions have yet to
introduce a system of recruiting skilled manpower from the open market. The Committee
believes that this delay has had an impact on the competency levels of public sector
banks in some areas and they have consequently lost some ground to foreign banks and
the newly set up private sector banks. The Committee urges that this aspect be given
urgent consideration and in case there is any extant policy driven impediments to
introducing this system, appropriate steps be taken by the authorities towards the needed
deregulation. Banks have to tone up their skills base by resorting, on an ongoing basis, to
lateral induction of experienced and skilled personnel, particularly for quick entry into
new activity/areas. The Committee notes that there has been considerable decline in the
56
scale of merit-based recruitment even at the entry level in many banks. The concept of
direct recruitment itself has been considerably diluted by many PSBs including the State
Bank of India by counting internal promotions to the trainee officers' cadre as direct
recruitment. The Committee would strongly urge the managements of public sector banks
to take steps to reverse this trend. The CFS had recommended that there was no need for
continuing with the Banking Service Recruitment Boards insofar as recruitment of
officers was concerned. This Committee, upon examination of the issue, reaffirms that
recommendation. As for recruitment in the clerical cadre, the Committee recommends
that a beginning be made in this regard by permitting three or four large. well-performing
banks, including State Bank of India, to set up their own recruitment machinery for
recruiting clerical staff. If the experience under this new arrangement proves satisfactory,
it could then pave the way for eventually doing away completely with the Banking
Service Recruitment Boards.
Action Taken - The public sector banks have been permitted to recruit from the open market or
by way of campus recruitment, skilled personnel in areas like information technology, risk
management, treasury operations, etc. As regards the recommendation in regard to discontinuing
the practice of recruitment of officers through Banking Services Recruitment Boards, Govt. may
furnish comments.
It seems apparent that there are varying levels of over manning in public sector banks.
The managements of individual banks must initiate steps to measure what adjustments in
the size of their work force are necessary for the banks to remain efficient, competitive
and viable. Surplus staff, where identified, would need to be redeployed on new business
and activities, where necessary after suitable retraining. It is possible that even after this
some of the excess staff may not be suitable for redeployment on grounds of aptitude and
mobility. It will, therefore, be necessary to introduce an appropriate Voluntary
Retirement Scheme with incentives. The managements of banks would need to initiate
dialogue in this area with representatives of labour.
Action Taken - While some of the public sector banks have introduced VRS after consultations
with Employees’ Unions, others are in the process of introducing such schemes.
The Committee would urge the managements of Indian banks to review the changing
training needs in individual banks keeping in mind their own business environment and
to address these urgently.
Action Taken - Banks have been advised to review the training needs and give more focus to
emerging areas like Credit Management, Treasury Management, Risk Management, Information
Technology, etc.
Structural Issues
The Committee has taken note of the twin phenomena of consolidation and convergence
which the financial system is now experiencing globally. In India also banks and DFIs
are moving closer to each other in the scope of their activities. The Committee is of the
view that with such convergence of activities between banks and DFIs, the DFIs should,
over a period of time, convert themselves to banks. There would then be only two forms
of intermediaries, viz. banking companies and non-banking finance companies. If a DFI
does not acquire a banking license within a stipulated time it would be categorized as a
57
non-banking finance company. A DFI which converts to a bank can be given some time
to phase in reserve requirements in respect of its liabilities to bring it on par with the
requirements relating to commercial banks. Similarly, as long as a system of directed
credit is in vogue a formula should be worked out to extend this to DFIs which have
become banks.
Action Taken - Based on the recommendations of the Khan Working Group on Harmonization
of the Role and Operations of banks and DFIs, RBI had released a Discussion Paper in January,
1999 for wider public debate. The feedback on the discussion paper indicated that while
universal banking is desirable from the point of view of efficiency of resource use, there is need
for caution in moving towards such a system by banks and DFIs. Major areas requiring attention
are the status of financial sector reforms, the state of preparedness of concerned institutions, the
evolution of regulatory-regime and above all a viable transition path for institutions which are
desirous of moving in the direction of universal banking. The Monetary and Credit Policy for the
year 2000 –2001 proposed to adopt the following broad approach for considering proposals in
this area:
The principle of “Universal Banking” is a desirable goal and some progress has
already been made by permitting banks to diversify into investments and long-
term financing and the DFIs to lend for working capital, etc. However, banks have
certain special characteristics and as such any dilution of RBI’s prudential and
supervisory norms for conduct of banking business would be inadvisable. Further,
any conglomerate, in which a bank is present, should be subject to a consolidated
approach to supervision and regulation.
Any DFI, which wishes to do so, should have the option to transform into bank
(which it can exercise), provided the prudential norms as applicable to banks are
fully satisfied. To this end, a DFI would need to prepare a transition path in order
to fully comply with the regulatory requirement of a bank. The DFI concerned
may consult RBI for such transition arrangements. Reserve Bank will consider
such requests on a case by case basis.
Mergers between banks and between banks and DFIs and NBFCs need to be based on
synergies and location and business specific complementarities of the concerned
institutions and must obviously make sound commercial sense. Mergers of public sector
banks should emanate from management of banks with Govt. as the common shareholder
playing a supportive role. Such mergers, however, can be worthwhile if they lead to
rationalization of workforce and branch network; otherwise the mergers of public sector
banks would tie down the managements with operational issues and distract attention
from the real issue. It would be necessary to evolve policies aimed at "rightsizing" and
redeployment of the surplus staff either by way of retraining them and giving them
appropriate alternate employment or by introducing a VRS with appropriate incentives.
This would necessitate the cooperation and understanding of the employees and towards
this direction, managements should initiate discussions with the representatives of staff
and would need to convince their employees about the intrinsic soundness of the idea, the
competitive benefits that would accrue and the scope and potential for employees' own
professional advancement in a larger institution. Mergers should not be seen as a means
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of bailing out weak banks. Mergers between strong banks/FIs would make for greater
economic and commercial sense and would be a case where the whole is greater than the
sum of its parts and have a "force multiplier effect"
Action Taken - The recommendation has been noted. A nonbanking finance company has since
been permitted to merge with a bank. Two banks in the private sector have also merged based on
synergies and business specific complementarities.
A ‘weak bank’ should be one whose accumulated losses and net NPAs exceed its net
worth or one whose operating profits less its income on recapitalization bonds is negative
for three consecutive years. A case by case examination of the weak banks should be
undertaken to identify those which are potentially revivable with a programme of
financial and operational restructuring. Such banks could be nurtured into healthy units
by slowing down on expansion, eschewing high cost funds/borrowings, judicious
manpower deployment, recovery initiatives, containment of expenditure etc. The future
set up of such banks should also be given due consideration. Merger could be a solution
to the problem of weak banks but only after cleaning up their balance sheets. If there is
no voluntary response to a takeover of these banks, it may be desirable to think in terms
of a Restructuring Commission for such public sector banks for considering other options
including restructuring, merger amalgamation or failing these closures. Such a
Commission could have terms of reference which, inter alia, should include suggestion of
measures to safeguard the interest of depositors and employees and to deal with possible
negative externalities. Weak banks which on a careful examination are not capable of
revival over a period of three years should be referred to the Commission.
Action Taken - In addition to the two definitions for identifying ‘weak’ banks recommended by
the Committee, RBI monitors banks to identify ‘potential weakness’ on the basis of five more
parameters (related to solvency, profitability and earnings) as recommended by the Working
Group on Restructuring of Weak Public Sector Banks (Chairman : Shri M.S.Verma ). In respect
of weak banks, a bank-specific restructuring programme aimed at turning around the bank by
reducing their cost of operation, and improving income levels, has been put in place. The
recommendation for setting up of a Restructuring Commission has not been considered.
However, the Union Budget for 2000 – 2001 has proposed setting up of a Financial
Restructuring Authority for a weak or potentially weak bank.
The policy of licensing new private banks (other than local area banks) may continue.
The startup capital requirements of Rs.100 crore were set in 1993 and these may be
reviewed. The Committee would recommend that there should be well defined criteria
and a transparent mechanism for deciding the ability of promoters to professionally
manage the banks and no category should be excluded on a priori grounds. The question
of a minimum threshold capital for old private banks also deserves attention and mergers
could be one of the options available for reaching the required capital thresholds. The
Committee would also, in this connection, suggest that as long as it is laid down (as now)
that any particular promoter group cannot hold more than 40% of the equity of a bank,
any further restriction of voting rights by limiting it to 10% may be done away with.
Action Taken - The policy of licensing new banks in the private sector has been reviewed by an
in-house Working Group set up by RBI. Based on the recommendations of the Working Group,
the licensing policy is being revised.
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The Committee is of the view that foreign banks may be allowed to set up subsidiaries or
joint ventures in India. Such subsidiaries or joint ventures should be treated on par with
other private banks and subject to the same conditions with regard to branches and
directed credit as these banks.
Action Taken - The recommendation has been examined. It has been felt that branch presence by
foreign banks would be better for the reason that the parent bank would stand ready to support
the branch in times of distress. Since subsidiaries would be set up as a joint stock companies with
limited liability, the parent bank’s liability to its subsidiary would be limited to its shareholding.
In the case of branches, the parent bank has responsibility both towards capital and management
whereas in the case of subsidiaries, the parent bank’s responsibility towards capital is limited.
All NBFCs are statutorily required to have a minimum net worth of Rs.25 lakhs if they
are to be registered. The Committee is of the view that this minimum figure should be
progressively enhanced to Rs.2 crores which is permissible now under the statute and that
in the first instance it should be raised to Rs.50 lakhs.
Action Taken - In respect of new NBFCs, which seek registration with the RBI and commence
the business on or after April 20,1999 the criteria in regard to minimum net worth has been
increased to Rs.2 crore, vide the Monetary and Credit Policy for the year 1999-2000.
Deposit insurance for NBFCs could blur the distinction between banks, which are much
more closely regulated, and the non- banks as far as safety of deposit is concerned and
consequently lead to a serious moral hazard problem and adverse portfolio selection. The
Committee would advise against any insurance of deposits with NBFCs.
Action Taken - The recommendation on not providing insurance cover for deposits with NBFCs
has been noted.
RBI should undertake a review of the current entry norms for urban cooperative banks
and prescribe revised prudent minimum capital norms for these banks. Though
cooperation is a state subject, since UCBs are primarily credit institutions meant to be run
on commercial lines, the Committee recommends that this duality in control should be
dispensed with. It should be primarily the task of the Board of Financial Supervision to
set up regulatory standards for Urban Cooperative Banks and ensure compliance with
these standards through the instrumentality of supervision.
Action Taken - The norms with regard to minimum capital requirements for urban cooperative
banks (UCBs) have been revised with effect from 1st April, 1998. Implementation of this
recommendation on doing away with duality of control over UCBs would involve amendments
to State Cooperative Societies Acts. The Government therefore, has to consider.
The Committee is of the view that there is need for a reform of the deposit insurance
scheme. In India, deposits are insured upto Rs.1 lakh. There is no need to increase the
amount further. There is, however, need to shift away from the 'flat' rate premiums to
'risk based' or 'variable rate' premiums. Under risk based premium system all banks
would not be charged a uniform premium. While there can be a minimum flat rate which
will have to be paid by all banks on all their customer deposits, institutions which have
riskier portfolios or which have lower ratings should pay higher premium. There would
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thus be a graded premium. As the Reserve Bank is now awarding CAMELS ratings to
banks, these ratings could form the basis for charging deposit insurance premium.
Action Taken - This has been accepted for implementation. The Working Group on Deposit
Insurance appointed by RBI has recommended the modalities for switching over to ‘risk based’
premium for deposit insurance and the recommendations are under examination.
The Committee is of the view that the inter-bank call and notice money market and inter-
bank term money market should be strictly restricted to banks. The only exception should
be the primary dealers who, in a sense, perform a key function of equilibrating the call
money market and are formally treated as banks for the purpose of their inter-bank
transactions. All the other present non-bank participants in the interbank call money
market should not be provided access to the inter-bank call money market. These
institutions could be provided access to the money market through different segments.
Action Taken - The phasing out of non-bank participants from inter-bank Call/Notice Money
market will be synchronized with the development of repo market. Keeping in view this
objective, RBI has widened the scope of repo market to include all entities having SGL Account
and Current Account in Mumbai, thus increasing the number of eligible non-bank entities to 64.
Further, the permission given to non-bank entities to lend in the call/notice money market by
routing their operations through PDs has been extended upto June, 2001. RBI aims to move
towards a pure interbank (including PDs) call/notice money market. With a view to further
deepening the money market and enable banks, PDs and AIFIs to hedge interest rate risk, these
entities are allowed to undertake FRA/IRSs as a product for their own balance sheet management
and for market making purposes. Mutual Funds, in addition to corporate are also permitted to
undertake FRAs/IRSs with these players. This measure is, inter alia, expected to help
development of a term money market.
There must be clearly defined prudent limits beyond which banks should not be allowed
to rely on the call money market. This would reduce the problem of vulnerability of
chronic borrowers. Access to the call market should be essentially for meeting unforeseen
swings and not as a regular means of financing banks’ lending operations.
Action Taken - RBI has advised banks to put in place comprehensive ALM System with effect
from 1.4.1999. ALM would effectively put a cap on reliance on call money market.
The RBI support to the market should be through a Liquidity Adjustment Facility under
which the RBI would periodically, if necessary daily reset its Repo and Reverse Repo
rates which would in a sense provide a reasonable corridor for market play. While there is
much merit in an inter-bank reference rate like a LIBOR, such a reference rate would
emerge as banks implement sound liquidity management facilities and the other
suggestions made above are implemented. Such a rate cannot be anointed, as it has to
earn its position in the market by being a fairly stable rate which signals small discrete
interest rate changes to the rest of the system.
Action Taken - The ILAF (Interim Liquidity Adjustment Facility) introduced earlier has served
its purpose as a transitional measure for providing reasonable access to liquid funds at set rates of
interest. In view of the experience gained in operating the interim scheme last year, an Internal
Group was set up by RBI to consider further steps to be taken. Following the recommendation of
the Internal Group, it was announced in the Monetary and Credit Policy Measures in April, 2000
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to proceed with the implementation of a full-fledged LAF. The new scheme will be introduced
progressively in convenient stages in order to ensure smooth transition.
In the first stage, with effect from June 5, 2000, the Additional CLF and level II
support to PDs will be replaced by variable rate repo auctions with same day
settlement.
In the second stage, the effective date for which will be decided in consultation
with banks and PDs, CLF and level I liquidity support will also be replaced by
variable rate repo auctions. Some minimum liquidity support to PDs will be
continued but at interest rate linked to variable rate in the daily repos auctions as
determined by RBI from time to time.
With full computerization of Public Debt Office (PDO) and introduction of RTGS
expected to be in place by the end of the current year, in the third stage, repo
operations through electronic transfers will be introduced. In the final stage, it will
be possible to operate LAF at different timings of the same day.
The minimum period of FD be reduced to 15 days and all money market instruments
should likewise have a similar reduced minimum duration
Action Taken -The minimum maturity of CDs has been reduced to 15 days
Foreign institutional investors should be given access to the Treasury bill market.
Broadening the market by increasing the participants would provide depth to the market.
Action Taken -FIIs have been permitted to invest in Treasury Bills, vide Monetary and Credit
Policy announced in April 1998.
With the progressive expansion of the forward exchange market, there should be an
endeavour to integrate the forward exchange market with the spot forex market by
allowing all participants in the spot forex market to participate in the forward market upto
their exposures. Furthermore, the forex market, the money market and the securities
should be allowed to integrate and the forward premia should reflect the interest rate
differential. As instruments move in tandem in these markets the desiderative of a
seamless and vibrant financial market would hopefully emerge.
Action Taken -With effect from June 11, 1998 Foreign Institutional investors were permitted to
take forward cover from Authorized Dealers to the extent of 15 per cent of their existing
investment as on that date. Any incremental investment over the level prevailing on June 11,
1998 was also made eligible for forward cover. The Monetary and Credit Policy for 1999-2000
has further simplified the procedure by linking the above mentioned limits to FIIs’ outstanding
investments as on March 31, 1999. In other words, 15 per cent of outstanding investment on
March 31, 1999 as well as the entire amount – 100 per cent - of any additional investment made
after this date will be eligible for forward cover. Further, any FII which has exhausted the limits
mentioned above can apply to RBI for additional forward cover for a further 15 percent of their
outstanding investments in India at the end of March 1999.
Rural and Small Industrial Credit
The Committee also recommends that a distinction be made between NPAs arising out of
client specific and institution specific reasons and general (agro-climatic and
environmental issues) factors. While there should be no concession in treatment of NPAs
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arising from client specific reasons, any decision to declare a particular crop or product or
a particular region to be distress hit should be taken purely on techno economic
consideration by a technical body like NABARD.
Action Taken -In the event of adverse agro-climatic and environmental factors, covering all
natural calamities, outstanding loans are converted/rescheduled/rephrased suitably. Agricultural
advances so rescheduled are provided relief for NPA classification. The decision to declare a
particular crop or product or a particular region as distress hit is at present vested in the
concerned District Administration Authority and the desirability of consulting NABARD which
is the technical body, before taking the decision, would be examined.
As a measure of improving the efficiency and imparting a measure of flexibility the
committee recommends consideration of the debt securitization concept within the
priority sector. This could enable banks, which are not able to reach the priority sector
target to purchase the debt from the institutions, which are able to lend beyond their
mandated percentage.
Action Taken -The recommendation of the Committee, which basically aims at ensuring that the
target for priority sector lending is achieved by each of the banks, has been re-examined. As of
March 2000, all public sector banks with the exception of UCO Bank have achieved the priority
sector lending target individually and the public sector banks as a Group has exceeded the target
at the macro level. The UCO Bank is short of achievement only marginally. Furthermore, every
year the Govt. has been settings up a Rural Infrastructure Development Fund (RIDF) in which all
banks which do not achieve the priority sector target contribute the amount of shortfall. Thus all
banks, directly or indirectly are able to fulfill the priority sector lending targets. Though the
concept of debt securitization is a novel idea, it will not have any practical application since it
will not help in augmenting the flow of credit to the priority sector nor will it help in addressing
the question of regional imbalances. It has, therefore, been decided that the recommendation
need not be considered for the present.
Banking policy should facilitate the evolution and growth of micro credit institutions
including LABs which focus on agriculture, tiny and small scale industries promoted by
NGOs for meeting the banking needs of the poor. Third-tier banks should be promoted
and strengthened to be autonomous, vibrant, effective and competitive in their operations.
Action Taken -In principle approval has been granted for setting up of 10 Local Area Banks
(LABs). Out of these, on account of non-compliance with the terms and conditions, the ‘in
principle’ approvals given to 4 banks were withdrawn. Of the remaining, 4 LABs have already
started functioning after obtaining licenses under Section 22 of Banking Regulation Act, 1949.
Banks should devise appropriate criteria suited to the small industrial sector and be
responsive to its genuine credit needs but this should not be by sacrificing cannons of
sound banking. Borrowers also need to accept credit discipline. There is also need to
review the present institutional set up of state level financial/industrial development
institutions.
Action Taken -48 recommendations of the S.L. Kapur Committee conveyed to banks for
implementation. As a further impetus to the flow of credit, banks have been advised that the
credit requirement of SSIs having credit limits upto Rs.5 crore, instead of Rs.4 crore, may be
assessed on the basis of 20% of the projected annual turnover.
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Regulations and Supervisions
The Committee recommends that to improve the soundness and stability of the Indian
banking system, the regulatory authorities should make it obligatory for banks to take
into account risk weights for market risks. The movement towards greater market
discipline in a sense would transform the relationship between banks and the regulator.
By requiring greater internal controls, transparency and market discipline, the supervisory
burden itself would be relatively lighter.
Action Taken -Banks are now required to assign capital for market risk. The disclosure
requirements of banks have been strengthened.
There is a need for all market participants to take note of the core principles and to
formally announce full accession to these principles and their full and effective
implementation.
Action Taken -We have endorsed the ‘Core Principles for Effective Banking Supervision’ and
complied with almost all of them. Our compliance with the Core Principles has been rated as
satisfactory by IMF Mission.
Proprietorial concerns in the case of public sector banks impact on the regulatory
function leading to a situation of ‘regulatory capture’ affecting the quality of regulation.
Action Taken -The prudential / regulatory norms stipulated by RBI are applicable to public
sector banks, private sector banks and foreign banks uniformly.
The Committee recommends that the regulatory and supervisory authorities should take
note of the developments taking place elsewhere in the area of devising effective
regulatory norms and to apply them in India taking into account the special
characteristics but not in any way diluting the rigor of the norms so that the prescriptions
match the best practices abroad. It is equally important to recognize that pleas for
regulatory forbearance such as waiving adherence to the regulations to enable some
(weak) banks more time to overcome their deficiencies could only compound their
problems for the future and further emasculate their balance sheets.
Action Taken -The Regulatory / Supervisory norms have been formulated taking into account
the best international practices. RBI has not waived adherence to the regulatory norms by any
individual bank or category of banks.
An important aspect of regulatory concern should be ensuring transparency and
credibility particularly as we move into a more market driven system where the market
should be enabled to form its judgments about the soundness of an institution. There
should be punitive penalties both for the inaccurate reporting to the supervisor or
inaccurate disclosures to the public and transgressions in spirit of the regulations.
Action Taken -We are moving towards greater transparency and Statutory Auditors of banks are
now under the obligation to report on the deviations from adherence to the prudential norms
prescribed by RBI in their ‘Notes to Accounts’. These observations are followed up by the RBI
with the concerned banks. In terms of the provisions of Section 47A of the B.R. Act, 1949, as
amended in 1994, the RBI can impose a penalty not exceeding Rs. 5 lakh or twice the amount
involved in such contravention or default where such amount is quantifiable whichever is more
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and where such contravention or default is a continuing one, a further penalty which may extent
to Rs.25000 for every day after the first day when the contravention or default continues.
The Committee recommends that an integrated system of regulation and supervision be
put in place to regulate and supervise the activities of banks, financial institutions and
non banking finance companies (NBFCs). The functions of regulation and supervision
are organically linked and we propose that this agency be renamed as the Board for
Financial Regulation and Supervision (BFRS) to make this combination of functions
explicit. An independent regulatory supervisory system which provides for a closely
coordinated monetary policy and banking supervision would be the ideal to work
towards.
Action Taken -BFS needs to be strengthened before regulatory functions are vested with it. It
was, therefore, felt that while the Committee’s recommendations to set up an agency named
Board for Financial Regulation and Supervision (BFRS) to provide an integrated system of
regulation and supervision over banks, FIs and NBFCs could be a long term objective. For the
time being, BFS may continue with its present mandate.
Legal and Legislative Framework
With the advent of computerization there is need for clarity in the law regarding the
evidentiary value of computer generated documents. The Shere Committee had made
some recommendations in this regard and the Committee notes that the Government is
having consultations with public sector banks in this matter. With electronic funds
transfer several issues regarding authentication of payment instruments, etc. require to be
clarified. The Committee recommends that a group be constituted by the Reserve Bank to
work out the detailed proposals in this regard and implement them in a time bound
manner.
Action Taken -The Group set up by the RBI has submitted its Report and the recommendations
are in various stages of implementation.
Although there is a provision in our legislation effectively prohibiting loans by banks to
companies in which their directors are interested as directors or employees of the latter
with liberalization and the emergence of more banks on the scene and with the induction
of private capital through public issue in some of the nationalized banks there is a
possibility that the phenomenon of connected lending might reappear even while
adhering to the letter of law. It is necessary to have prudential norms which are addressed
to this problem by stipulating concentration ratios in terms of which no bank can have
more than a specified proportion of its net worth by way of lending to any single
industrial concern and a higher percentage in respect of lending to an industrial group. At
present, lending to any single concern is limited to 25% of a bank’s capital and free
reserves. This would seem to be appropriate along with the existing enhanced figure of
50% for group exposure except in the case of specified infrastructure projects. Similarly,
concentration ratios would need to be indicated, even if not specifically prescribed, in
respect of any bank’s exposure to any particular industrial sector so that in the event of
cyclical or other changes in the industrial situation, banks have an element of protection
from over exposure in that sector. Prudential norms would also need to be set by way of
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prescription of exposure limits to sectors particularly sensitive to asset price fluctuations
such as stock markets and real estate. As it happens, Indian banks do not have much
exposure to the real estate sector in the form of lending for property development as
distinct from making housing loans. The example of banks in East and South East Asia
which had over extended themselves to these two sectors has only confirmed the need for
circumspection in this regard. We would leave the precise stipulation of these limits and,
if necessary, loan to collateral value ratios to the authorities concerned. The
implementation of these exposure limits would need to be carefully monitored to see that
they are effectively implemented and not circumvented, as has sometimes happened
abroad, in a variety of ways. Another salutary prescription would be to require full
disclosure of connected lending and lending to sensitive sectors.
Action Taken -As the Committee has noted, Section 20 of the Banking Regulation Act, 1949
prohibits banks from entering into any commitment for granting of any loan or advance to or on
behalf of any of its directors, any firm in which any of its directors is interested as partner,
manager, employee or guarantor or any company of which any of the directors of the banking
company is a director, managing agent, manager, employee, or guarantor or in which he holds
substantial interest or, any individual in respect of whom any of its directors is a partner or
guarantor. The RBI has, as noted by the Committee, laid down prudential ceilings on exposures
to single / group of borrowers. Banks on their own, have also prescribed exposure ceilings on
single borrower and group of borrowers. As regards the recommendation that prudential norms
be set by way of prescription of exposure limits to sensitive sectors, i.e. those sectors where asset
prices are subject to fluctuations, RBI has already put in place a cap on a bank’s exposure to
share market. The banks on their own have limited their exposure to real estate business. Banks
are expected to set norms for lending to any particular industrial sector in their lending policy.
Banks have been advised to disclose in ‘Notes on Account’ to their balance sheets, lending to
sensitive sectors, (i.e., advances to sectors such as, capital market, real estate, etc.) and such
other sectors to be defined as ‘sensitive’ by RBI from time to time with effect from the year
ended March 31, 2000.
The Committee recommends that the RBI should totally withdraw from the primary
market in 91 days Treasury Bills; the RBI could, of course, have a presence in the
secondary market for 91 days Treasury Bills. If the 91 days Treasury bill rate reflects
money market conditions, the money and securities market would develop an integral
link. ….The Committee also recommends that foreign institutional investors should be
given access to the Treasury bill market.
Action Taken -The withdrawal of RBI from the primary market in 91 day Treasury Bills is the
long term objective. The pace of implementation of the recommendation should depend upon the
development and depth of the Govt. securities market. One of the objectives of evolving the
system of Primary Dealers is to improve the underwriting and market making capabilities in
Government securities market so that RBI could eventually withdraw from primary
subscriptions. This will be possible only when Primary Dealers are capable of taking
devolvement, if any, to the full extent.
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3.5 RAGURAM RAJAN COMMITTEE RECOMMENDATION ANALYSIS:
Macro Economic Framework
India’s economy has become more open and it is impossible to control capital flows in
either direction, except for the very short term. Given this, the real exchange rate, which
is the key factor determining India’s competitiveness, is influenced by factors such as
productivity growth and demand supply imbalances that are not changed by central bank
intervention against the dollar. The RBI should formally have a single objective, to stay
close to a low inflation number, or within a range, in the medium term, and move steadily
to a single instrument, the short-term interest rate (repo and reverse repo) to achieve it.
Steadily open up investment in the rupee corporate and government bond markets to
foreign investors after a clear monetary policy framework is in place. India should accept
the possible costs of subsequent currency appreciation as a legitimate down payment on
the more robust markets and financing we will enjoy in the future. We should also relieve
pressure from inflows by becoming more liberal on outflows, especially in forms that can
be controlled if foreign currency becomes scarce. For instance, we should encourage
greater outward investment by provident funds and insurance companies when inflows
are high.
Broadening Access to Finance
Allow more entry to private well-governed deposit-taking small finance banks offsetting
their higher risk from being geographically focused by requiring higher capital adequacy
norms, a strict prohibition on related party transactions, and lower allowable
concentration norms. The small finance bank proposed emulates the Local Area Bank
initiative by the RBI that was prematurely terminated, though the details of the
Committee’s proposal differs somewhat. The intent is to bring local knowledge to bear on
the products that are needed locally, and to have the locus of decision making close to the
banker who is in touch with the client. This would suggest rethinking the entire
cooperative bank structure, and moving more to the model practiced elsewhere in the
world, where members have their funds at stake and exercise control, debtors do not have
disproportionate power, and government refinance gives way to refinancing by the
market. The Committee would suggest implementation of a strong prompt corrective
action regime so that unviable cooperatives are closed, and would recommend that well-
run cooperatives with a good track record explore conversion to a small bank license,
with members becoming shareholders.
The second organizational structure the Committee proposes makes it easier for large
financial institutions to ‘bridge the last mile’. Large institutions have the ability to offer
commodity products like savings accounts at low cost, provided the cost of delivery and
customer acquisition is reduced. They should be able to use existing networks like cell-
phone kiosks or kirana shops as business correspondents to deliver products. Liberalize
the banking correspondent regulation so that a wide range of local agents can serve to
extend financial services. Use technology both to reduce costs and to limit fraud and
misrepresentation.
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Offer priority sector loan certificates (PSLC) to all entities that lend to eligible categories
in the priority sector. Allow banks that undershoot their priority sector obligations to buy
the PSLC and submit it towards fulfillment of their target. Any registered lender
(including microfinance institutions, cooperative banks, banking correspondents, etc.)
who has made loans to eligible categories would get ‘Priority Sector Lending
Certificates’ (PSLC) for the amount of these loans. The Committee recommends
liberalizing interest rates while increasing safeguards that prevent exploitation.
Liberalize the interest rate that institutions can charge, ensuring credit reaches the poor,
but require full transparency on the actual effective annualized interest cost of a loan to
the borrower, periodic public disclosure of maximum and average interest rates charged
by the lender to the priority sector, only loans that stay within a margin of local estimated
costs of lending to the poor be eligible for PSLCs. The Committee believes that through a
combination of transparency, incentives, and eventually competition, liberalized interest
rates to the poor can be kept within reasonable limits, and liberalization would enhance,
and improve the sources of, credit to the poor. The Committee suggests that the
government pay more directly for the social obligations it wants banks to undertake (for
example, by reducing priority sector obligations and, over time, paying directly for
PSLCs).
Leveling the Playing Fields
The greatest source of uneven privileges in the banking system stems from ownership.
The public sector banks, accounting for 70 per cent of the system, enjoy benefits but also
suffer constraints, with the latter increasingly dominating, There is little evidence that the
ownership of banks makes any difference to whether they undertake social obligations,
once these are mandated or paid for. So on net, what matters is how an ownership
structure will affect the efficiency with which financial services are delivered. The
majority of this Committee does not see a compelling reason for continuing government
ownership. There are other activities where government attention and resources are more
important. A parallel approach is to undertake reforms that would remove constraints on
the public sector banks, even while retaining government ownership. Intermediate steps
such as reducing the government’s ownership below 50 per cent while retaining its
control (as suggested by the Narasimham Committee). Unfortunately, ideology has
overtaken reasoned debate in this issue. The pragmatic approach, which should appeal to
practical people of all hues, is to experiment, as China does so successfully, and to use
the resulting experience to guide policy. One aspect of the pragmatic approach would be
to sell a few small underperforming public sector banks, possibly through a strategic sale
(with some protections in place for employees), so as to gain experience with the selling
process, and to see whether the outcomes are good enough to pursue the process more
widely.
Create stronger boards for large public sector banks, with more power to outside
shareholders (including possibly a private sector strategic investor), devolving the power
to appoint and compensate top executives to the board.
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After starting the process of strengthening boards, delink the banks from additional
government oversight, including by the Central Vigilance Commission and Parliament,
with the justification that with government-controlled boards governing the banks, a
second layer of oversight is not needed. Further ways to justify reduced government
oversight is to create bank holding companies where the government only has a direct
stake in the holding company. Another is to bring the direct government stake below 50
per cent, perhaps through divestment to other public sector entities or provident funds, so
that the government (broadly defined) has control, but the government (narrowly defined)
cannot be considered the owner.
Be more liberal in allowing takeovers and mergers, including by domestically
incorporated subsidiaries of foreign banks. The commitment to allow foreign banks
subsidiaries to participate in takeovers will substantially increase the pressure on
domestic banks.
A second way to foster growth and competition, but also to strengthen banks, is to de-
license the process of branching immediately. The RBI can retain the right to impose
restrictions on the growth of certain banks for prudential reasons, but this should be the
exception rather than the norm. One objective of branch licensing is to force banks into
under-banked areas in exchange for permission to enter lucrative urban areas. This is
again an obligation that will have to be revisited as competition increases in urban areas,
but it can be explicitly achieved today by instituting a service norm—for every x savings
accounts that are opened in high income neighborhoods, y low-frill accounts have to be
opened in low income neighborhoods. The service provision obligation could become
traded (much as the priority sector norms earlier), with small banks or cooperatives
acquiring certificates for the excess number of accounts they provide and selling them to
deficient banks. The government may provide added incentives by buying certificates,
and should take over this obligation from banks over time.
Allow holding company structures, with a parent holding company owning regulated
subsidiaries. The holding company should be supervised by the Financial Sector
Oversight Agency, with each regulated subsidiary supervised by the appropriate
regulator.
Creating More Efficient and Liquid Markets
The Committee believes that there are substantial efficiencies to be had by consolidating
the regulation of trading under one roof (SEBI)—this will allow scope economies to be
realized, improve liquidity, and increase competition. Moreover, all markets are
interconnected, so fragmenting regulation weakens our ability to regulate.
Encourage the introduction of markets that are currently missing such as exchange traded
interest rate and exchange rate derivatives.
Stop creating investor uncertainty by banning markets. If market manipulation is the
worry, take direct action against those suspected of manipulation. As an example,
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products such as currency futures and commodity options are banned. A market that is
banned can obviously not attain liquidity or efficiency. Equally problematic, a missing
market can hamper the efficiency of other markets also. For instance, the absence of
interest rate futures can hurt the Treasury market. The recent practice of closing down
commodity markets when the price reaches high levels is unfortunate to say the least.
Create the concept of one consolidated membership of an exchange for qualified
investors (instead of the current need to obtain memberships for each product traded).
Consolidated membership should confer the right to trade all the exchange’s products on
a unified trading screen with consolidated margining.
Encourage the setting up of ‘professional’ markets and exchanges with a higher order
size that are restricted to sophisticated investors, where more sophisticated products can
be traded. Some exchanges, clearing corporations, and depositories are close to being
world class as is the clearing, settlement, and depository infrastructure. New entry by
professional exchanges catering to institutional/sophisticated customers could help, as
could greater competition between elements of the infrastructure.
Create a more innovation friendly environment, speeding up the process by which
products are approved by focusing primarily on concerns of systemic risk, fraud, contract
enforcement, transparency and inappropriate sales practices.
Allow greater participation of foreign investors in domestic markets as in Proposal 2.
Increase participation of domestic investors by reducing the extent to which regulators
restrict an institutional investor’s choice of investments. Move gradually instead to a
‘prudent man’ principle where the institutional investor is allowed to exercise judgments
based on what a prudent man might seem to be appropriate investments.
Creating a Growth Friendly Regulatory Environment
Problems with existing financial regulatory and supervisory structure:
First, the pace of innovation is very slow. Products that are proposed to be
introduced in India (though well-established elsewhere in the world) take several
years to get regulatory approval.
Second, excessive regulatory micromanagement leads to a counter-productive
interaction between the regulator and the regulated.
Third, some areas of the financial sector have multiple regulators, while others
that could pose systemic risks have none. Both situations, of unclear
responsibility, and of no responsibility, are dangerous.
Fourth, regulators tend to focus on their narrow area to the exclusion of other
sectors, leading to balkanization even between areas of the financial sector that
naturally belong together. Financial institutions are not able to realize economies
of scope in these areas, leading to inefficiency and slower growth.
70
Finally, regulatory incentive structures lead to excessive caution, which can be
augmented by the paucity of skills among the regulator’s operational staff relative
those of the regulated. Such caution could actually exacerbate risks.
Rewrite financial sector regulation, with only clear objectives and regulatory principles
outlined.
Parliament, through the Finance Ministry, and based on expert opinion as well as the
principles enshrined in legislation, should set a specific remit for each regulator every
five years. Every year, each regulator should report to a standing committee (possibly the
Standing Committee on Finance), explaining in its annual report the progress it has made
on meeting the remit. The interactions should be made public.
Regulatory actions should be subject to appeal to the Financial Sector Appellate Tribunal,
which will be set up along the lines of, and subsume, the Securities Appellate Tribunal.
Supervision of all deposit taking institutions must come under the RBI. Situations where
responsibility is shared, such as with the State Registrar of Cooperative Societies, should
gradually cease. Drawing a lesson from the current crisis in industrial countries, the
Committee recommends that joint responsibility for monetary policy and banking
supervision continue to be with the RBI, and that the RBI play an important role in the
joint supervision of conglomerates and systemically important NBFCs.
The Ministry of Corporate Affairs (MCA) should review accounts of unlisted companies,
while SEBI should review accounts of listed companies.
A Financial Sector Oversight Agency (FSOA) should be set up by statute. The FSOA’s
focus will be both macro-prudential as well as supervisory; the FSOA will develop
periodic assessments of macroeconomic risks, risk concentrations, as well as risk
exposures in the economy; it will monitor the functioning of large, systemically
important, financial conglomerates; anticipating potential risks, it will initiate balanced
supervisory action by the concerned regulators to address those risks; it will address and
defuse inter-regulatory conflicts. The FSOA should be comprised of chiefs of the
regulatory bodies (with a chair, typically the senior-most regulator, appointed from
amongst them by the government), and should also include the Finance Secretary as a
permanent invitee. The FSOA should have a permanent secretariat comprised of staff
including those on deputation from the various regulators.
The Committee recommends setting up a Working Group on Financial Sector Reforms
with the Finance Minister as the Chairman. The main focus of this working group would
be to shepherd financial sector reforms.
The Committee also notes the consumer faces an integrated portfolio of services. It is
increasingly important for the consumer to have a ‘one stop’ source of redress for
complaints, a financial ombudsman. Set up an Office of the Financial Ombudsman
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(OFO), incorporating all such offices in existing regulators, to serve as an interface
between the household and industry.
The Committee recommends strengthening the capacity of the Deposit Insurance and
Credit Guarantee Corporation (DICGC) to both monitor risk and resolve a failing bank,
instilling a more explicit system of prompt corrective action and making deposit
insurance premia more risk-based.
Creating a Robust Infrastructure for Credit
Expedite the process of creating a unique national ID number with biometric
identification. More sources of information, such as payments of rent or of utilities/cell-
phone bills, need to be tapped to build individual records of payment, which can then
open doors to credit and expand access.
The Committee recommends movement from a system where information is shared
primarily amongst institutional credit providers on the basis of reciprocity to a system of
subscription, where information is collected from more sources and a subscriber gets
access to data subject to verification of need to know and authorization to use of the
subscriber by the credit bureau.
On-going efforts to improve land registration and titling—including full cadastral
mapping of land, reconciling various registries, forcing compulsory registration of all
land transactions, computerizing land records, and providing easy remote access to land
records—should be expedited, with the Centre playing a role in facilitating pilots and
sharing experience of best practices.
Restrictions on tenancy should be re-examined so that tenancy can be formalized in
contracts, which can then serve as the basis for borrowing.
The powers of SARFAESI that are currently conferred only on banks, public financial
institutions, and housing finance companies should be extended to all institutional
lenders.
Encourage the entry of more well-capitalized ARCs, including ones with foreign backing.
If India is to have a flourishing corporate debt market, corporate public debt, which is
largely unsecured, needs to have value when a company becomes distressed.
The Committee outlines a number of desirable attributes of a bankruptcy code in the
Indian context, many of which are aligned with the recommendations of the Irani
Committee.
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CHAPTER 4
FINDINGS /
CONCLUSIONS
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4.1 BASEL III:
The new capital requirements under Basel III would have a positive impact for banks as they
raise the minimum core capital, introduce counter-cyclical measures, and enhance banks’ ability
to conserve core capital in the event of stress through a conservation capital buffer. The liquidity
standard requirements would benefit the Indian banks in managing the pressures on liquidity in a
stress scenario more effectively. However, in case of inconsistent implementation of the new
framework among different countries would lead to international arbitrage thereby resulting in
disruption of global financial stability.
Basel III framework’s impact on the financial system would be significant, as its implementation
would lead to reduced risk of systemic banking crises as the enhanced capital and liquidity
buffers together lead to improved management of probable risks emanating due to counterparty
defaults and or liquidity stress circumstances. The stricter norms on Inter-bank liability limits
would reduce the interdependence of the banks and the reduced interconnectivity among the
banks would save the banks from contagion risk during the times of crises.
There would be a strong impact on the weaker banks leading to their crowding out. As the
conditions deteriorate and the regulatory position gets even more intensive, the weaker banks
would definitely find it very challenging to raise the required capital and funding. Further, this
would affect their business models apart from tilting the banking businesses in favor of large
financial institutions and thereby tilting the competition. In the light of the increased regulatory
oversight on the organizational structure and capital structure of the financial firms (mainly
banks), there would be scenarios where the banks may look towards reorganizing their legal
identity by resorting to mergers & acquisitions and disposals of portfolios, entities, or parts of
entities wherever possible.
It is observed that banking operations might experience a reduced pace in view of the
heightened supervisory vigil on the activities of the banks in terms of ensuring the new capital
standards and the new liquidity ratios– LCR and NSFR.
Impact of BASEL III on Loan Spread
Impact of Basel III on bank loan spreads was estimated using 2 different methodologies viz., the
representative bank approach of Mervin King, 2010 employed for BCBS study and other one
employing the OECD approach. The results of the estimations for bank loan spread for every
increase in capital ratio assuming RWAs unchanged are presented for comparison in below
mentioned table.
74
Comparison of results for estimation of bank loan spread for SCBs
Increase in Capital Ratio
(percentage
points)
Under representative
Bank Model (King 2010)
employed by BCBS
Under
OECD model
approach
Assuming RWAs unchanged
+1 31.40 15.63
+2 45.20 31.26
+3 59.00 46.89
+4 72.80 62.52
+5 86.60 78.15
+6 100.40 93.78 Source: Dr. Swamy “Basel III: Implication on Indian Banking”
The results of the estimations for bank loan spread for every increase in capital ratio assuming
for decline in RWAs are presented for comparison in below mentioned table.
Comparison of results for estimation of bank loan spread for SCBs
Increase in Capital Ratio
(percentage
points)
Under representative
Bank Model (King 2010)
employed by BCBS
Under
OECD model
approach
Assuming for decline in RWAs
+1 22.00 15.01
+2 31.00 30.02
+3 41.00 45.03
+4 50.00 60.04
+5 59.00 75.05
+6 68.00 90.06 Source: Dr. Swamy “Basel III: Implication on Indian Banking”
The study also offers a comparison of the bank lending spreads for different countries estimated
under the OECD approach in below mentioned table.
Increase in bank lending spreads for a one percentage point increase in bank capital
PARTICULARS USA EUROPE JAPAN INDIA
Bank Lending
Spreads (Basis
Points)
20.05 14.30 8.40 15.63
Source – OECD
The estimation for increase in bank lending spread is found to be comparatively greater in the
United States (mainly due to a higher return on equity and a higher share of risk-weighted assets
75
in bank balance sheets) and lower in Japan (mostly due to a lower return on equity and a higher
share of lending assets in bank balance sheets).
Capital Requirements of Indian Banks
This study has estimated the approximations of additional capital requirements of Indian banks
in the wake of the new Basel III regime in the Indian context. This would enable the banks to
plan their capital raising activity in tune with regulatory requirements. The important assumption
made in the estimation process was that RWAs of these banks would grow by 10 percentage
points annually in Scenario-1 and 12% per annum in Scenario-2 and 15% in Scenario-3.
This increase in RWAs is considered because of the reasoning that the banks grow their loan
book size approximately in the range of 20-25% and also considering the past trend of RWAs.
The estimates of this study are compared with that of other comparable studies by reputed
professional research houses in India.
Summary of findings of different studies on capital requirement of Indian banks
Research House Estimations
Swamy (2012) Study
Swamy (2012) study (this A particular study) estimates that with an
assumed growth of RWAs at 10%, Indian banks would require
additional minimum tier-1 capital of INR 2,51,106.57 Crores. With
RWAs growth at 12% and 15%, the requirement would be in the
order of INR 3,36,390.41 Crores and INR 4,74,168.60 Crores
respectively.
Ernst & Young study
Ernst & Young study anticipates that by 2019, the Indian banking
system is projected to require additional capital of INR 4,31,517
crores of which 70% will be required in the form of common
equity.
ICRA Study ICRA study pegs this figure at INR 6,00,000 crores of which 70-
75% will be the requirement of public sector banks.
PWC study PWC study estimates that Indian banks would have to raise Rs.
600,000 crore in external capital over next 8-9 years, out of which
70%-75% would be required for the public sector banks and rest for
the private sector banks. Further, the study observed that one
percentage point rise in bank’s actual ratio of tangible common
equity to risk-weighted assets (CAR) could lead to a 0.20 per cent
drop in GDP.
Fitch
Ratings
Fitch estimates the additional capital requirements at about INR 2.5
lakh crores to 2.75 lakh crores for Indian banks
Macquarie Indian banks would have to go on a massive capital raising to the
extent of over USD 30 billion (INR 1.67 lakh crores) over the next
five years to cater to their growth requirements and Basel-III
implementation charges
CRISIL
Indian banks may have to raise a total of about Rs 2.4 trillion to
meet growth needs in compliance with the Reserve Bank of India’s
final guidelines on capital adequacy requirements under the new
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Basel III norms by March 2018. Source: Dr. Swamy “Basel III: Implication on Indian Banking”
Cost Benefit Analysis of BASEL III for Indian Banking
It is believed that higher capital requirements under Basel III would prevent possible systemic
crisis and benefit the economy. With this argument in the backdrop, I thought it wise to estimate
the cost of crisis in terms of output loss in GDP in order to facilitate a cost-benefit analysis of the
higher capital requirements under Basel III. Accordingly, I have translated the probability of a
crisis into expected losses in the GDP level in the Indian context based on the internationally
acknowledged assumptions for analysis.
The output loss (compared to the pre-crisis level) for different values of discount factors are
estimated in terms of loss of GDP (at factor costs) in constant prices, With value at 0.025, the
cumulative loss-in-output due to the crisis would be INR 16,01,971 crores for a period of ten
years. Similarly, for values at 0.03, 0.04, 0.05, 0.06 and 0.07 the respective cumulative loss-in-
output are estimated at INR 16,46,065 crores, INR 17,31,568 crores, INR 18,13,581 crores, INR
18,92,213 crores and INR 19,67,570 crores.
Cost Benefit Analysis of BASEL III for Indian Banking
In INR Crores
Estimation Highlights Cost Benefits
Cost estimated as additional
minimum tier-1 capital with
RWAs assumed at 10%.
2,51,106.57
---
Prevention of loss-in- output
due to a crisis with value at
0.025
--- 16,01,971.00
Cost estimated as additional
minimum tier-1 capital with
RWAs assumed at 12%.
3,36,390.41
---
Prevention of loss-in- output
due to a crisis with value at
0.025
--- 16,01,971.00
Cost estimated as additional
minimum tier-1 capital with
RWAs assumed at 15%.
4,74,168.60
---
Prevention of loss-in- output
due to a crisis with a value at
0.025
--- 16,01,971.00
Source: Dr. Swamy “Basel III: Implication on Indian Banking”
Though Basel III implementation is entailed undoubtedly with some costs, the significance of
Basel III should be seen in context of reducing the probability of banking crises at affordable
costs and aiding for a sound financial system.
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BASEL III Timeline – How it is Effective:
The timeline proposed under Basel-III has widely pleased the proponents of stricter standards
though the standards are relatively aggressive and make for safer banks that can better absorb
losses when deep recessions and financial crises suddenly strike. Nevertheless, some critics of
systemically financial institutions are concerned with the ample time permitted for banks to
comply. Nobel Prize-winning economist Joseph Stiglitz is quoted to have opined that delay in
quicker and fuller implementation is exposing the public to continued risk. The argument
sounded by Stiglitz is that banks will continue to pocket their profits instead of pooling the
money as a capital buffer and continue to take big risks as long as possible to collect big bonuses
while they still can make a healthy return on their relatively lower level of capital required.
However, in the Indian context, the timeline for Basel III implementation may not have any
serious impact as the banks are relatively well positioned for smoother implementation of new
capital standards with an exception of some of the public sector banks. The arguments held out
against the timeline in the case of global banks and particularly that of U.S need not hold good in
the case of Indian banks, which are not exposed to volatile and toxic assets. Furthermore, in view
of the increased disclosure norms, banks would be guided by the market forces to increasingly
Basel III compliant well before the suggested timeline by RBI.
In effect, the Basel III timeline offers is a prudent approach by allowing the struggling banks
ample time to ramp up their capital without harming their business, but still compelling them to
make gradual progress towards the desired finish. In the meanwhile, banks that can comply
earlier will likely do so quite ahead of the timeline suggested.
Conclusion of BASEL norm
It needs to be clearly understood that Basel III is an evolution rather than a revolution for many
banks. It is an improvement over the existing Basel II framework; the most significant among the
differences for banks are the introduction of liquidity and leverage ratios, and enhanced
minimum capital requirements. Basel III provides for a timeline of implementation that is quite
acceptable in the case of Indian context as it is observed that Indian banks are relatively well
positioned for smoother implementation of the new standards.
While the effective implementation of Basel III will demonstrate to the stakeholders that the
bank is quite well positioned, a speedy implementation will lead to contribute to bank’s
competitiveness by delivering better management insight into the business, enabling it to take
strategic advantage of future opportunities.
One of the main significant challenges posed by Basel III apart from the increased capital
standards is that of creating a new risk management culture with a greater rigor and
accountability. In effect, Basel III is changing the way the banks look at their risk management
functions and might imply them to go for a robust risk management framework to ensure a true
enterprise risk management. From the regulator’s angle, it requires RBI to be more proactive,
and stricter in terms of regulatory supervision surveillance.
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In order to achieve better risk management and to comply with the revised regulatory reporting
requirements, the risk management teams would require quick and speedy access to quality data
that is clean and accurate. This would call for proper data flow and management systems in tune
with the evolving risk management practices. Effective data management systems are not going
to be cheap as they involve significant costs in their acquisition, up gradation and maintenance.
As Basel III aims at providing a solid foundation for financially sound banking, it is both a
challenge and an opportunity for Indian banks. The opportunity comes in the form of acquiring
new quality capital, selection of technology architecture and redesigning of the risk management
framework for effective risk management as well as risk reporting. The challenge is for the bank
managements and the regulator in successfully implementing the new standards as per the
suggested timeline and win over the stakeholders.
4.2 NARSIMHAM COMMITTEE:
An asset can be classified as doubtful if it is in the substandard category for 18 months in
the first instance and eventually for 12 months and loss if it has been so identified but not
written off.
The Committee has noted that Non-Performing Assets (NPAs) figures do not include
advances covered by Government guarantees which have turned sticky and which in the
absence of such guarantees would have been classified as NPAs. The Committee is of the
view that for the purposes of evaluating the quality of asset portfolio such advances
should be treated as NPAs.
Banks and financial institutions should avoid the practice of “ever greening” by making
fresh advances to their troubled constituents only with a view to settling interest dues and
avoiding classification of the loans in question as NPAs.
The Committee believes that the objective should be to reduce the average level of net
NPAs for all banks to below 5% by the year 2000 and to 3% by 2002. For those banks
with an international presence the minimum objective should be to reduce gross NPAs to
5% and 3% by the year 2000 and 2002, respectively, and net NPAs to 3% and 0% by
these dates.
For banks with a high NPA portfolio, the Committee suggests consideration of two
alternative approaches, in the first approach, all loan assets in the doubtful and loss
categories – which in any case represent bulk of the hard core NPAs in most banks,
should be identified and their realizable value determined. These assets could be
transferred to an Asset Reconstruction Company (ARC) which would issue to the banks
NPA Swap Bonds representing the realizable value of the assets transferred. An
alternative approach could be to enable the banks in difficulty to issue bonds which could
form part of Tier II capital. This will help the banks to bolster capital adequacy which has
been eroded because of the provisioning requirements for NPAs. As the banks in
difficulty may find it difficult to attract subscribers to bonds, the government will need to
guarantee these instruments which would then make them eligible for SLR investments.
79
Priority Sector Lending: The Committee has noted the reasons why the Government
could not accept the recommendation for reducing the scope of directed credit under
priority sector from 40% to 10%. The Committee recommends that the interest subsidy
element in credit for the priority sector should be totally eliminated and even interest
rates on loans under Rs.2 lakh should be deregulated. The Committee believes that it is
the timely and adequate availability of credit rather than its cost which is material for the
intended beneficiaries.
Recruitment: The Committee notes that public sector banks and financial institutions
have yet to introduce a system of recruiting skilled manpower from the open market. The
Committee believes that this delay has had an impact on the competency levels of public
sector banks. The Committee on the Financial System (CFS), 1991 had recommended
that there was no need for continuing with the Banking Service Recruitment Boards
insofar as recruitment of officers was concerned. This Committee, upon examination of
the issue, reaffirms that recommendation.
Structural Issues: In India also banks and Development Finance Institutions (DFIs) are
moving closer to each other in the scope of their activities. The Committee is of the view
that with such convergence of activities between banks and DFIs, the DFIs should, over a
period of time, convert themselves to banks. There would then be only two forms of
intermediaries, viz. banking companies and non-banking finance companies. If a DFI
does not acquire a banking license within a stipulated time it would be categorized as a
non-banking finance company.
The Committee is of the view that foreign banks may be allowed to set up subsidiaries or
joint ventures in India. Such subsidiaries or joint ventures should be treated on par with
other private banks
Though cooperation is a state subject, since Urban Cooperative Banks (UCBs) are
primarily credit institutions meant to be run on commercial lines, the Committee
recommends that this duality in control should be eliminated. It should be primarily the
task of the Board for Financial Supervision to set up regulatory standards for Urban
Cooperative banks and ensure compliance with these standards through the
instrumentality of supervision.
Rural and Small Industrial Credit: The Committee recommends that a distinction be made
between NPAs arising out of client specific and institution specific reasons and general
(agro-climatic and environmental issues) factors. While there should be no concession in
treatment of NPAs arising from client specific reasons, any decision to declare a
particular crop or product or a particular region to be distress hit should be taken purely
on techno-economic consideration by a technical body like NABARD.
As a measure of improving the efficiency and imparting a measure of flexibility the
committee recommends consideration of the debt securitization concept within the
priority sector. This could enable banks, which are not able to reach the priority sector
80
target to purchase the debt from the institutions, which are able to lend beyond their
mandated percentage.
Banking policy should facilitate the evolution and growth of micro credit institutions
including LABs which focus on agriculture, tiny and small scale industries promoted by
NGOs for meeting the banking needs of the poor. Third-tier banks should be promoted
and strengthened to be autonomous, vibrant, effective and competitive in their operations.
The Committee recommends that an integrated system of regulation and supervision be
put in place to regulate and supervise the activities of banks, financial institutions and
non-banking finance companies (NBFCs). The functions of regulation and supervision
are organically linked and we propose that this agency be renamed as the Board for
Financial Regulation and Supervision (BFRS) to make this combination of functions
explicit.
The Board for Financial Regulation and Supervision (BFRS) should be given statutory
powers and be reconstituted in such a way as to be composed of professionals. At
present, the professional inputs are largely available in an advisory board which acts as a
distinct entity supporting the BFS. Statutory amendment which would give the necessary
powers to the BFRS should develop its own autonomous professional character. The
Committee, taking note of the formation of BFS, recommends that the process of
separating it from the Reserve Bank qua central bank should begin and the Board should
be invested with requisite autonomy and armed with necessary powers. However, with a
view to retain an organic linkage with RBI, the Governor, RBI should be head of the
BFRS.
No further recapitalization of banks: So far, a sum of Rs.20, 000 crore has been expended
for recapitalization and to the extent to which recapitalization has enabled banks to write
off losses, this is the cost which the Exchequer has had to bear for the bad debts of the
banks. Recapitalization is a costly and, in the long run, not a sustainable option.
Recapitalization involves budgetary commitments and could lead to a large measure of
monetization. The Committee urges that no further recapitalization of banks be
undertaken from the Government budget.
At present, the laws stipulate that not less than 51% of the share capital of public sector
banks should be vested with the Government and similarly not less than 55% of the share
capital of the State Bank of India should be held by the Reserve Bank of India. The
current requirement of minimum Government of India/Reserve Bank of India
shareholding is likely to become a constraint for raising additional capital from the
market by some of the better placed banks unless Government also decides to provide
necessary budgetary resources to proportionately subscribe to the additional equity,
including the necessary premium on the share price, so as to retain its minimum
stipulated shareholding. The Committee believes that these minimum stipulations should
be reviewed. It suggests that the minimum shareholding by Government/RBI in the
equity of nationalized banks and SBI should be brought down to 33%.
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The Reserve Bank as a regulator of the monetary system should not be also the owner of
a bank in view of the potential for possible conflict of interest. It would be necessary for
the Government/RBI to divest their stake in these nationalized banks and in the State
Bank of India.
The Committee strongly urges that there should be no recourse to any scheme of debt
waiver in view of its serious and deleterious impact on the culture of credit.
4.3 RAGHURAM RAJAN COMMITTEE:
Based on the analysis in the chapter, the Committee proposes the steps below as a means to
upgrade the policy framework to meet the challenges that lie ahead. The Committee emphasizes
that these recommended reforms should be seen as a package.
Implementing them partially would make the individual reforms far less effective; indeed, the
Committee cautions that implementing the recommendations selectively could in some cases be
counterproductive. For instance, liberalizing external commercial borrowings by corporate
without allowing for greater exchange rate flexibility would increase incentives for borrowing
via foreign currency-denominated debt, which could be risky.
The Committee views proper sequencing of the recommended reforms as important but, rather
than lay out a specific and rigid timeline, prefers to take a more practical approach of indicating
which reforms could be undertaken in the short run (the next 1–2 years) and which ones should
be seen as longer-term objectives (over a 3–5 year horizon).
Monetary Policy
Move towards establishing RBI’s primary objective as the maintenance of low and stable
inflation. Implicit in this objective will be to maintain growth consistent with the
economy’s potential and to ensure financial sector stability. The objective could be
translated quantitatively into a number, a number that can be brought down over time, or
a range that will be achieved over a medium-term horizon (say, two years). This will
have to be done with the full support of the government, which would simultaneously
commit to maintain fiscal discipline (i.e., stick to the FRBM deficit reduction path) and
not hold the central bank accountable for either the level or volatility of the nominal
exchange rate. The inflation objective would initially have to be set on the basis of a
widely-recognized indicator such as the WPI or CPI, notwithstanding the conceptual and
practical problems with targeting these measures of inflation. Measurement issues will
need to be tackled as a priority and, over the initial medium-term horizon, the RBI will
have to be transparent about what its headline objective implies for inflation based on
other price indexes.
The government would make the RBI accountable for the medium-term inflation
objective, with the terms of this accountability initially being laid out in an exchange of
letters between the Government of India and the RBI.
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The RBI should be given full operational independence to achieve the inflation objective.
It would be useful to enshrine this operational independence and the inflation objective in
legislation, but also strengthen it through clarifying public statements on the respective
roles of the RBI and the government.
The RBI would progressively reduce its intervention in the foreign exchange market.
The RBI should make its operational framework clear, and supplement this with more
frequent and concise statements about its assessments of macroeconomic developments,
the balance of risks in the economy, and projections for output growth and inflation.
The RBI’s Monetary Policy Committee should take a more active role in guiding
monetary policy actions. This Committee should meet more regularly; its
recommendations and policy judgments should be made public with minimal delays.
The RBI should develop a model for forecasting inflation and make the details of the
model public. The model will require refinement as techniques and data improve;
feedback from analysts and academics will facilitate this process. It will have to be made
clear (and the public and market participants will quickly learn) that the model is
intended to guide monetary policy decisions but not in a slavish manner or in a manner
that precludes a healthy dose of judgments.
Capital Account
Remove restrictions on outflows by corporate and individuals, There are already few
restrictions on these outflows, but formal removal of controls, easing of procedures and
elimination of the need for permissions, as well as a strong push to encourage outward
flows would send a strong signal that the government is committing to increased financial
integration and the policies that are needed to support it, Easing of restrictions on
vehicles such as mutual funds and domestic fund managers, that individuals could use for
international portfolio diversification, would be an important ancillary reform.
The registration requirements on foreign investors should be simplified. One transparent
approach would be to end the foreign institutional investor (FII) framework for
investment in equities and, instead, allow foreign investors (including NRIs) to have
direct depository accounts. The distinctions between FIIs, NRIs and other investors could
also be eliminated, with the intent being to eliminate any privileges or costs they may
experience with respect to domestic investors.
Remove the ceilings on foreign portfolio investment in all companies, with a narrow
exception for national security considerations—treat foreign investors just like local
shareholders.
Remove restrictions on capital inflows based on end-uses of funds. These do not serve
much purpose anyway, since they are difficult to monitor.
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Remove restrictions on inward FDI, with a narrow exception for national security
considerations.
Liberalize, then eliminate, restrictions on foreign investors’ participation in rupee
denominated debt, including corporate and government debt.
Remove regulations that hinder international diversification by domestic institutional
investors. Insurance companies, as well as government pension and provident funds
should especially be encouraged to diversify their holdings by investing abroad.
Reduce restrictions on borrowing by domestic firms and banks, whether this borrowing
occurs offshore or onshore, in Indian rupees or foreign currencies. For instance, the
ceiling on corporate external commercial borrowing could be steadily raised for the next
few years until eliminated. If there is excess demand during the transitional phase to
removal of restrictions, borrowing rights could be auctioned. Stability concerns raised by
exchange mismatches between bank assets and liabilities should be addressed by
supervisory and prudential measures.
Fiscal Policy
Continue to reduce levels of consolidated government deficit and public debt (ratios to
GDP); resume progress towards targets specified under the Fiscal Responsibility and
Budget Management Bill. Amend the FRBM Act so as to bring the off-balance-sheet
borrowing by the government integrally into calculations of the government budget
deficit and public debt.
Reduce the Statutory Liquidity Ratio to a level consistent with prudential needs; switch to
direct bond financing of new deficits. Similarly, regulators of pension funds and
insurance companies should set regulations on fund portfolio holdings so as to maximize
the welfare of beneficiaries, and not so as to mobilize the purchase of government bonds.
Transition away from providing sops for exporters in response to currency appreciation.
While many of the recent sops are in the process of being removed, it is important to
curtail expectations of similar sops being offered in the future in the event of currency
appreciation.
Other Reforms
Remove the remaining restrictions on the currency futures market in the short term
(prohibitions against foreign institutional investors, against non-resident Indians, against
products other than futures, against underlying trades other than the rupee–US dollar rate,
and against positions greater than US$5 million). Permitting onshore currency derivatives
markets with no restrictions on participation is an important measure that includes
elements of financial market regulation as well as capital account liberalization. These
markets could be developed fairly quickly as the technical infrastructure for trading of
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these derivatives could be built up soon on the backbone of the existing securities trading
infrastructure.
Improve the structure of public debt management to increase depth and transparency of
this market.
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