BANKING SECTOR REFORMS

Major Reform Initiatives:

When was it initiated? Banking sector reforms is a part and parcel of the financial sector reforms, and was initiated in 1991. Why was it necessary? Was necessary so as to remove the deficiencies in the financial sector, particularly in the banking sector to strengthen the economic reforms. What was the Object? The objectives of reforms were to strengthen the Indian banks, make them internationally competitive and encourage them to play an effective role in the acceleration of the process of growth. Also, measures were to be adopted for improving the productivity, efficiency and profitability of the banking system. To place the Indian Banking system at par with international standards in respect of capital adequacy and other prudential norms. The operational rigidities in credit delivery system were to be removed to ensure allocation efficiency and achievement of social objectives. The policy initiatives taken in this regard were largely based on the recommendations of Narasimham Committee I & II on financial sector and Banking sector reforms

Major Highlights of Narasimham Committee I Report

Phased reductions of Statutory Pre-emptions (SLR to 25% CRR to 10%) Interest Rate on CRR Balances (Cash balance above the basic minimum of 3%) Phasing Out Directed Credit Programme (Constituents of the priority sector should be redefined) Interest Rate Deregulation (Gradual move towards market determined interest rates) Income Recognition: (Assets should be recognised at their realisable value. Uniform accounting policy should be adopted. NPA recognition)

Asset Classification: (Standard, Sub Standard, doubtful and loss asset) Transparency: Tax Treatment of Provisions: Loan Recovery: (tribunals) Tackling Doubtful Debts:(A special asset reconstruction fund co. should be set up) Restructuring the Bank: (Consolidations) Entry of Private Banks: encourage pvt. sector participation Branch Licensing: (it should be abolished) Foreign Banks Supervision of Banks: over-regulated banking env. Control of Banking System: Only RBI & not RBI & Ministry of Fin.

Major Highlights of Narasimham Committee II Report

Merger in Strong public sector banks & not merger of strong and weak. Should have greater autonomy with respect to recruitment and other personnel related matters and general management Restructuring and Recapitalisation of weak public sector banks Rather than focusing only on asset management banks should emphasize on asset-liability mgt. instead. Better understanding of the financial market in terms of interdependence of various market segments. Greater specialisation of banks in niche areas as retail, agriculture, ssi, corporate financing etc.

Banks should place greater reliance on non fund business such as advisory and consultancy services. Banks should concentrate on management of credit risk and better mgt. of NPA advances. To improve the financial health of the banks the capital adequacy ratio be raised to 9% by march 2000 and 10% by 2002. Assets should be classified as doubtful if it is in the substandard category for 18 months in the first instance and eventually 12 months and LOST if it had been so identified but not written off. Also Govt. guaranteed advances which has turned sticky should be classified as NPAs. The committee recommended that a gen prov. of 1% should be introduced on standard assets and avoid the practice of evergreening.

The Committee recommended that the Govt. should guarantee issue of bonds for tier II capital by banks. These instruments would be eligible for SLR investments. Banks should continue with their present practice of priority sector lending. Branch managers should be made fully responsible for identification of beneficiaries, interest subsidy and so on. Functions of Board and Management should be reviewed and also recommended strongly for professionalisation and depoliticisation of bank boards, specially in respect of non official directors.

Banking Sector Reforms: Phase I (Narsimham Committee I Recommendation)

Summary

Deregulation of Interest Rate Structure Progressive reduction of Pre-emptive reserves Liberalisation of the branch expansion policy Introduction of prudential norms to ensure capital adequacy, proper income recognition classification of assets based on their quality and provisioning against bad and dd. Decreasing the emphasis laid on directed credit and phasing out the concessional rate of interest to priority sectors Deregulation of the entry norms for Pvt. Sector an Foreign banks Permitting private and public sector banks to access the capital market Setting up of the asset reconstruction fund Constituting the special debt recovery tribunal Freedom to appoint chief executive and officers of the bank Changes in constitution of the board Bringing NBFCs under the ambit of regulatory framework

Banking Sector Reforms: Phase II (Narsimham Committee II Recommendation)

Summary

Capital Adequacy:

CAR be raised from 8 to 10% by 2002 100 % Fxd Income portfolio mark to market by 2001 5% mkt risk weight for Fixed income securities Commercial Risk weight (100%) to Govt guaranteed advances

Asset Quality:

Banks should aim to reduce gross NPA to 3% and net NPA to 0% by 2002 90 day overdue norm to be applied for cash based income recognition Govt. guaranteed irregular accounts to be classified as NPAs Asset reconstruction COs to take over NPAs Directed credit obligation to be reduced from 40 to 10% Mandatory general provisions of 1% of standard assets and specific provisions to be made tax deductible.

System and Methods:

Banks to start recruitment of skilled, specialised manpower from the market

Overstaffing to be dealt with redeployment and right sizing PSBs to be given flexibility in remuneration structure Rapid introduction of computerisation and technology Only 2 categories 1) banks and 2) NBFCs Merges to be driven by market and business consideration Weak banks to convert to narrow banks, restructure or close down Entry of New Pvt Sector Banks and Foreign Banks to continue Banks to be given greater financial autonomy, and min Govt. shareholdings to be reduced to 33% fro 55% for SBI and to 51% for other PSBs

Industry Structure:

Regulation Supervision

Banking regulation and supervision to be progressively delinked from monetary policy Board for Financial Reconstruction and Supervision to be constituted with statutory powers Greater emphasis on public disclosure than disclosures to regulators

Legal Amendments:

Broad range of legal reforms to facilitate recovery problems Introduction of laws governing electronic funds transfer Amendments in the BRAct , Nationalisation Act and SBI Act to allow greater autonomy

MAJOR REFORM INITIATIVES

1. Greater Operational Freedom due to Deregulatory Measures:

Banks now enjoy greater operational freedom in terms of conducting their business and employing measures to confront market forces. But, such freedom is of course, limited within the frontiers of prudential norms and prescribed RBI guidelines. Control, regulation and supervision of the banking system has been liberalized to a considerable extent in the following directions:
Sharp

reduction in pre-emption: (SLR 25% & CRR 5%) Controls on credit & Interest rate deregulation (there has been a considerable disbanding of administered interest rates except a part on priority sector adv.) Improvement in payment and settlement mechanism: Enhancement in Short-term liquidity Management: ( Introduction of pure inter-bank call money market and auction-based repos-reserve for short-term liquidity Management ) Pricing of Government Securities: (Market determined pricing system)

2. Greater Managerial Autonomy:

The PSBs (Public sector banks) can henceforth acquire any company like a private sector, NBFC or other business to increase their balance sheet size. They can also exit non-profitable areas. For any such move, they will not have to take specific clearances from the government. Also the public sector banks will be permitted to pursue new lines of businesses as a part of overall business strategy. Banks are now allowed to issue preference shares since it is treated as regulatory capital under Basel norm. Public sector banks can now raise capital from equity market up to 49% of their paid-up capital. Banks with a good track record of profitability have greater flexibility in recruitment and branch rationalization.

Banks could now diversify their: Business Activities: Like leasing, insurance, infrastructure financing, factoring, gold banking, investment banking, asset management, credit cards etc. Product portfolio: New instruments have been introduced for greater flexibility and better risk management: e.g. interest rate swaps, forward rate agreements, liquidity adjustment facility for meeting day-to-day liquidity mismatch With banks permitted to diversify into long-term finance and DFIs into working capital, guidelines have been put in place for the evolution of universal banking in an orderly fashion.

3. Competition Enhancing Measures: New private sector banks have been set up and foreign banks permitted to expand their operations in India directly or through
subsidiaries.

Overseas investment Limits: 1) Limits for investment in overseas markets by banks, mutual funds and corporates have been liberalised. 2) Banks have also been allowed to set up Offshore Banking Units in Special Economic Zones. 3) The overseas investment limit for corporates has been raised to 100% of net worth and the ceiling of $100 million on prepayment of external commercial borrowings has been removed. 4) MFs and corporates can now undertake FRAs with banks. 5) Indians are now allowed to maintain resident foreign currency (domestic) accounts. 6) Full convertibility for deposit schemes of NRIs has been introduced. FDI investment in Private Banks: The limit for foreign direct investment in private banks has been increased from 49% to 74% and the 10% cap on voting rights has been removed. In addition, the limit for foreign institutional investment in private banks is put at 49%.

Reduction of Government equity in banks: Government holdings are reducing and strong banks have been allowed to access the capital market for raising additional capital. Consolidation as a strategy to meet Global Competition: (At present only one Indian bank figures in S&Ps list of 300 top banks viz; SBI which ranks 82nd.

4.Institutional and Legal Initiatives

The Recovery of Debts due to Banks and Financial Institutions Act, (DRT Act) 1993- Under the DRT act Debt Recovery Tribunals were set up for recovery of loans of banks and financial institution. These tribunals have reduced the recovery period to about a year as against 5to 7 year in the civil court. SARFAESI (Securitization and reconstruction of financial assets and enforcement of security interest) Act, 2002. This has largely been possible due to SARFAESI Act, 2002. This act has empowered banks with regard to recovery of defaulted loan. Setting up of new institutions: Several new institutions have been set up including the National Securities Depositories Ltd., Central Depositories Services Ltd., Credit Information Bureau India Ltd. (for information sharing on defaulters as also other borrowers.), Clearing Corporation of India Ltd (CCIL) which acts as central counter party for facilitating payments and settlement system relating to fixed income securities and money market instruments.

4.Institutional and Legal Initiatives

Move towards Basel II Accord: The New Basel Capital Accord, often referred to as the Basel II Accord or simply Basel II, was approved by the Basel Committee on Banking Supervision of Bank for International Settlements in June 2004 and suggests that banks and supervisors implement it by beginning 2007, providing a transition time of 30 months. It is estimated that the Accord would be implemented in over 100 countries, including India. Basel II takes a three-pillar approach to regulatory capital measurement and capital standards - Pillar 1 (minimum capital requirements); Pillar 2 (supervisory oversight); and Pillar 3 (market discipline and disclosures).

Pillar 1 spells out the capital requirement of a bank in relation to the credit risk in its portfolio, which is a significant change from the one size fits all approach of Basel I, and specifies new standards for minimum capital requirements, along with the methodology for assigning risk weights on the basis of credit risk and market risk and Also specifies capital requirement for operational risk. Pillar 2 Enlarges the role of banking supervisors and gives them power to review the banks risk management systems. Pillar 3 Defines the standards and requirements for higher disclosure by banks on capital adequacy, asset quality and other risk management processes.

Approach of the Reserve Bank of India to Basel II Accord: The Reserve Bank of India (RBI) had asked banks to move in the direction of implementing the Basel II norms. The aim was to reach the global best standards in a phased manner, taking a consultative approach rather than a directive one. In anticipation of Basel II, RBI had requested banks to examine the choices available to them and draw a roadmap for migrating to Basel II. The RBI had set up a steering committee to suggest migration methodology to Basel II. Based on recommendations of the Steering Committee, in February 2005, RBI had proposed the Draft Guidelines for Implementing New Capital Adequacy Framework covering the capital adequacy guidelines of the Basel II accord. RBI had also specified that the migration to Basel II will be effective March 31, 2007 and has suggested that banks should adopt the new capital adequacy guidelines and parallel run effective April 1, 2006. Over time, when adequate risk management skills have developed, some banks may be allowed to migrate to the Internal Ratings Based approach for credit risk measurement.

Risk Management Norms: The Basel II norms for capital adequacy concentrate heavily on risk management systems (RMS). Basel II addresses credit risk as well as operational risk. Credit risk estimates the potential loss because of the inability of counter-party to meet its obligation. On the other hand, operational risk results from errors that can be made in instructing payments or settling transactions. Basel II requires the banks to have a CAR (capital adequacy ratio) of 12.5%. Most banks do not have this level of CAR. To increase their capital base, the banks have to raise new funds through various sources. That is why we are seeing the rush of banks to the capital market. Disclosure Norms: As a move towards greater transparency, banks were directed to disclose the following additional information in the 'Notes to Accounts' in their balance sheets (i) maturity pattern of loans and advances, investment securities, deposits and borrowings, (ii) foreign currency assets and liabilities, (iii) movements in NPAs and (iv) lending to sensitive sectors as defined by the Reserve Bank from time to time.

Supervisory Measures: 1) Establishment of the Board for Financial Supervision as the apex supervisory authority for commercial banks, financial institutions and non-banking financial companies. 2) Introduction of CAMELS supervisory rating system, move towards risk-based supervision, consolidated supervision of financial conglomerates, strengthening of off-site surveillance through control returns. 3) Recasting of the role of statutory auditors, increased internal control through strengthening of internal audit. 4) Strengthening corporate governance, enhancing due diligence on important shareholders, fit and proper tests for directors. Technology Related Measures: Implementation of technology is important as technology helps banks to reduce transaction cost and time. The banks, in turn, can then pass the benefit on to customers by slashing service charges and most importantly: giving speedy service. The other benefits are faster branch reconciliation and as a result reduced hassles in the banks internal functioning too. (Examples are CBS, RTGS etc in trading of Govt. Securities.)

PRUDENTIAL REGULATIONS

There are 2 models for bank regulation: economic regulation and prudential regulation.

Economic regulatory model involves issues like constraints on interest rates, tightening entry norms and directed lending etc. The method was extensively followed by the RBI in the pre-reform period but evidence indicates that the model hampered the productivity and efficiency of banks. Hence RBI adopted Prudential regulation Prudential Regulation it calls for imposing regulatory capital level to maintain the health of banks and soundness of the financial system. It allows greater play for market forces than economic regulatory model RBI issued prudential norms based on the NC Report.

Prudential Norms strive to ensure:

Financial Safety Soundness and Solvency of Banks

Prudent business without excessive risk taking

Banking reforms were initiated by implementing Prudential Norms consisting of CAR; Asset Classification; Income Recognition & Provisioning. This has ever-since been broadened as per international standards.

Capital Adequacy

Banks are required to maintain unimpaired minimum capital funds equivalent to the prescribed ratio on the aggregate of risk weighted assets and other exposures.
CAR is a measure of the amount of banks capital expressed as a % of its risk weighted credit exposure. The capital framework was introduced for Indian SCBs based on Basel Committee proposals (1988), which prescribes 2 tiers of capital for the banks: T-I & T-II

Tier I capital:

The most permanent and readily available support against unexpected losses

T-I Capital is the one which absorbs losses without a bank being required to cease trading and T-II capital is the one which absorbs losses in the event of winding up. Tier 1 capital, the more important of the two, consists largely of shareholders' equity. This is the amount paid up to originally purchase the stock (or shares) of the Bank (not the amount those shares are currently trading for on the stock exchange), retained profits and subtracting accumulated losses. In simple terms, if the original stockholders contributed $100 to buy their stock and the Bank has made $10 in profits each year since, paid out no dividends and made no losses, after 10 years the Bank's tier one capital would be $200. Regulators have since allowed several other instruments, other than common stock, to count in tier one capital. These instruments are unique to each national regulator, but are always close in nature to common stock. These are commonly referred to as upper tier one capital. In India they include:

Paid up capital, Statutory reserves and share premium Capital Reserves (only surplus from sale of assets), Other disclosed free reserves minus equity investments in subsidiaries, intangible assets, losses in the current period, and those brought forward from previous year.

Tier II capital:

Tier II capital is secondary bank capital that includes items such as undisclosed reserves, general loss reserves, subordinated term debt, and more:

Undisclosed Reserves & fully paid up cumulative perpetual preference shares Revaluation Reserves (arising out of Revaluation of assets) General Provision and loss reserves Hybrid debt capital instruments Subordinate debt that is fully paid up

Capital Adequacy Norms: (CAR)

CAR is the measure of the amount of a banks capital expressed as a % of its risk weighted credit exposures. As per the BASEL accord of 1988 the following principles of capital adequacy were suggested:

A bank must hold equity capital at least 8% of its assets when multiplied by appropriate risk weights. The four risk weights suggested by the Basel committee were 0%, 1.6%, 4% and 8% for various categories of assets. When capital falls below the min requirement, shareholders may contribute the loss by recapitalising or else the regulatory authority may liquidate the bank

Initially RBI directed banks to maintain a minimum CAR of 8% on the risk wtd assets. The committee on Banking Sector Reforms (1998) suggested a further tightening of the CAR to 9% by march 00 As on March 02 all SCBs (except 5) recorded CAR in excess of 9% but by 2005-2006 only 2 old pvt sector banks were defaulters.

Basel Capital Accord

The bank for international settlement (BIS) is an international organisation which fosters international monetary and financial co-operation and serves as a bank for central banks. The Basel Committee established by the Central Bank Governors of the group countries at the end of 1974, meets regularly 4 times a year. It has about 30 technical work groups and task forces. India is a member of the G-20 and advises the financial stability forum (FSF). The Core Principles Liaison Group set up by Basel Committee on Banking Supervision (BCBS) discusses proposals for revising the capital adequacy framework. BACKGROUND: Different CBs have different norms in their respective countries but to provide a level playing field the group of 15 most industrial countries agreed on some common rules which came to be known as Basel Accord.

New BC Accord

The norms laid down in 1988 helped to arrest the erosion of banks capital ratios. But were not found to be adequate due to their perceived rigidities. Moreover with the passage of time the Financial Markets, Financial Intermediaries, Banking business, Risk Management practices have undergone significant changes. These baseline capital adequacy norms were found to be inadequate as they almost entirely addressed credit risk. Therefore BCBS (banking spv) brought out a revised capital adequacy framework in june 99 with a second revision on Jan 01 effective from Jan 2005. The primary objective of the new accord are: (i) promotion of safety and soundness of the fin sys (ii) enhancement of competitive equality (iii) constitution of a more comprehensive approach to address risk.

The new Basel Accord is based on three mutually reinforcing pillars:

Minimum

capital requirement Supervisory Review Process Market Discipline

Minimum capital requirement: New framework maintains both the current definition of capital and minimum requirement of 8% of cap to risk wtd assets. Basel II has recommended 3 approaches: Standardised Approach expands the scale of risk wts and uses external credit rating (less complex banks) The foundation internal risk based (IRB) approach - banks with more advanced risk mgt capabilities with strict methodologies and disclosure standards. Advanced internal risk based (AIRB) approach - it takes into a/c operational risk as well

Supervisory review process: The supervisors would be responsible for evaluating the way the banks are measuring risk and robustness of the system and processes. The 4 basic and complementary principles are:

Ability of assessing its overall CAR to its risk profile + strategy to maintain its capital level Supervisors should review and evaluate the banks internal capital adequacy assessment and strategy and its compliance with regulatory ratios Supervisors expect banks to operate above the min regulatory capital ratios. Supervisors should seek to intervene at an early stage to prevent capital from dipping bellow prudential levels

Market Discipline: It can be bolstered through enhanced disclosures by banks. It provides several areas for disclosure:

Maturity pattern of deposits, borrowings, investments, advances, foreign currency assets, liabilities, movements in NPA, lending to sensitive sectors, total advances against shares, total investment made in equity shares, convertible debentures etc.