M 88

The Changing Role of RBI in Bank Supervision with the Introduction of Risk Based
Parameters
Abstract: The role of RBI has undergone through a rigorous change over the period of time.
Earlier, it was a common perception that the roles of the commercial banks are credit creation in
the economy. The commercial banks were used as conduit by which savings of household and
corporate got channelized into productive investment which was meant to facilitate growth of the
nation. On the other hand, major task of RBI is to control the credit depending on the economic
environment of the national as well as international level. If inflation rate is quite high and it is
reducing the purchasing power of the common mass, RBI raises the different key rates such as
Cash Reserve Ratio, Statutory Liquidity Ratio, REPO and Reverse REPO which curb the credit
creating capacity of the banks and reduces the money circulation in the economy. Similarly, if
the economy is facing a liquidity crunch situation, RBI reduces gradually all the key rates as a
policy matter to enhance the liquidity in the economy. The bank has to simultaneously ensure
three functions- liquidity, profitability as well as the safety of the fund collected from the
depositors. The unique characteristics of the banking sector which distinguishes it from
manufacturing as well as trading organizations is that in the later cases raw materials are
purchased or produced and finished product is offered to the end customer but the bank is
purchasing money from the lenders and it is also selling the money to the corporate borrower.
When the banks are accepting deposit from the corporate and the household, banks have to pay
certain interest on the deposit and when it is lending the fund to the borrower, the banks are

entitled to receive the interest .The lending rate of the bank is quite high with respect to its
borrowing rate, the differential of which is known as Net Interest Margin. The banks are required
to create certain assets by providing the loan and advances. If they are unable to realize the
assets, banks are unable to meet their liability such as interest payment on deposit. Therefore,
business of the banking sector itself contains risk. Thus banks have to maintain certain amount of
capital as a safety cushion. As a consequence, risk management is a major area of concern for
banks. Another distinguishable feature of the bank is that if any company goes for bankruptcy, it
creates a knee jerking effect to its shareholders, suppliers, creditors, employees as well as the
customers but once a bank is suffering from solvency risk , it adversely affects shareholders,
suppliers, creditors, employees as well as multiple depositors of the bank who have deposited
their hard earned money in the bank with utmost good faith that they will receive certain amount
of assured returns depending on the nature of deposits. One of the major threats that the Indian
banking sector is facing is the accumulation of the Non Performing Assets due to the faulty
credit appraisal mechanism followed by the banks.
It is being noticed in the contemporary Central Banking practices globally that the financial
supervision architecture is in a state of flux. In the recent past the global banking practices have
faced a number of jugglery and malpractices such as window dressing, over and undervaluation
of mortgage and collateral, overpricing the default risk and under pricing the credit risk. In the
year 1998, a group of 10 countries met in Basel, Switzerland and the Basel Committee of
Banking Supervision under the auspices of Bank of International settlement was established. The
objective was to create uniform risk management policy across the globe. The primary focus of
Basel I was to control the credit risk of the bank. Basel II norms came afterwards and Basel II
incorporates operation risk as well as market risk apart from the credit risk. Basel III is a recently
2

developed area of the banking sector where major impetus was provided towards the liquidity
risk. The Macro Economic Assessment group was established in February, 2010 by the chairs of
the financial stability board and Basel Committee on Banking Supervision to coordinate an
assessment of macroeconomic implications. To protect the depositors interest, the central bank
of every nation has to maintain a close supervision to all the participants of money market to
ensure that they are conforming to the international benchmark .To protect the shareholders
interest, corporate governance mechanism of the bank is expected to be quite sound which are
closely watched by the apex body of the capital market of each nation. The banking sector is a
unique sector where two regulatory apex bodies are discharging the role of the watchdog so that
irregularities and scam cannot take place and maximum justice can be provided to the all
stakeholders of the bank.
The objective of the research paper is to identify the changing role of RBI, interpret the changes
which have taken place with the implementation of Basel norms, analyze the role of the central
banks as controller of the liquidity of the nation, demonstrate the challenges of measuring,
mitigating and managing of different type of risks, develop the strategies to combat against Non
Performing assets and critically analyze the corporate governance framework of the banks. The
methodology used for preparing this research paper is based on the statutory and non statutory
disclosure provided by the banks in the public domain in the form of their quarterly, half early
and annual reports. The authenticity of the disclosure made by the bank is more or less beyond
any doubt or question as it has to conform to the norms stipulated by different regulatory apex
bodies simultaneously such as SEBI clause 49, the Companies Act 1956, the Banking act 1949
as well as International Basel regulations. The proposed research paper will incorporate the
secondary information available on Risk management in banking, scope and direction of the
3

successive Basel norms and corporate governance practice followed by Indian banks. This paper
will focus a paradigm shift in the role of RBI. It will provide a new dimension in the literature of
corporate governance, risk management in banking and ethical obligations of the banks as well
as successful implantation of International Basel Norms on capital adequacy framework by
issuance of relevant norms and guidelines.
Keywords: Risk Management, Corporate Governance, Basel Norm, Capital adequacy ratio.

The Changing Role of RBI in Bank Supervision with the Introduction of Risk Based
Parameters
Introduction: The Central Bank is the apex body of the money market of every nation. In India,
central bank is known as Reserve Bank of India, in Bangladesh, it is referred as Bangladesh
Bank, in USA it is called as Federal Bank, in Europe it is known as European Central Bank.
Irrespective of the name and the nation, previously the roles and responsibilities of the central
banks were confined to certain stereotype activities such as controller of credit in the economy,
lending the fund to the commercial banks as the lender of the last resort, providing the loan and
advances to the Government of the nation in the form of deficit financing, controller of the
foreign exchanges by devaluating and revaluating the home currency to ensure that the value of
the currency remains within a particular predefined range as a policy resolution. In this respect,
the RBIs role in banking supervision has changed significantly from 1992 which should be
considered as milestone year in the history of Indian banking sector.
Background Story: The great depression in USA during 1930 created a knee jerking effect in
the global economy. All on a sudden almost all the major banks in USA went for bankruptcy.
The top management of these banks siphoned their fund into European market and parked the
fund into Swiss banks. It was a bolt from the blue for all USA citizens who suddenly realized in
one fine morning that there was hardly any money in their bank accounts. As a result their
purchasing power decreased to a significant extent and all the macro economic variables such as
income, employment, output and price started to move to the downward direction in a vicious

circle. On the other hand, exorbitant amount of cash piled up in different banks of Switzerland
due to money laundering. Germany started to borrow fund on a continuous basis from the banks
of Switzerland to purchase the arms which would be used in war. This was considered as
sovereign debt of Germany. The fascist leader Hitler financed the entire expense of World War II
by borrowing the money from Swiss banks. At the end of World War II, German economy
crashed down and German was unable to repay their debts which created an adverse impact on
the fundamental of all the banks which were operating in Switzerland as huge bad debt was
accumulated in their books of account. The Basel Committee of Banking Supervision was
formed in 1945 to create a framework which can save the economy of the member nations.
Initially the G-7 nations and oil rich nations were the members of this committee. Basel
committee met in 1945, 1954, 1961, 1966 and 1972. The sudden collapse of Soviet Russia and
emergence of BRIC nations compelled Basel committee to include India as a member nation in
1984. Implementation of Basel accord took place in 1992 when waves of privatization,
liberalization and globalization entered in India.
Objective of the Paper:
To focus on the role of the Central Bank in both pre and post liberalization phase in India
To demonstrate how the Basel accords has changed the supervisory role of the RBI
To analyze how RBI discharges its duties as the controller of the liquidity in the changed
circumstances
To evaluate the risk management strategies followed by Indian banks and assess the
corporate governance framework of the banking sector player.
Research gap: Several research papers have been authored on corporate governance in banking.
(Perera, 2006; Sharma, 2008;Alexander, 2009;Lo, 2009). Numerous articles are also available in

the field of Risk Managment in banking ( Tschemernjak, 2004; Doff, 2008;Williams, 2010 ;
Jarrow, 2011). Mulitple research precedences are evident in the sphere of banking supervision
and monitoring (Isik, 2007; WU, 2008;Gersbach, 2009;Hussain, 2012) . So far my knowledge is
concerned hardly any work has been done on the changing role of RBI taking into account the
perspective of the risk management and risk based supervision .
Literature Survey: Section 5(b) of the Banking Regulation Act, 1949 defines banking as
accepting for the purpose of lending or investment of deposits of money from the public,
repayable on demand or otherwise and withdraw- able by cheque, draft and order or otherwise.
Two basic functions of a bank are 1) acceptance of public deposits 2) lending or investment of
such deposits. Accepting deposits from public indicates that a banker can accept money as
deposit who offers it as such. Of course, a banker has the right to deny the acceptance of deposit
on the grounds of improper introduction and inadequate identification. During the prime
ministerial tenure of Mrs. Indira Gandhi, nationalization of Indian banks took place in 1969
where fourteen banks were nationalized. In 1980, there was another wave of nationalization of
Indian banks where seven banks with deposit more than Rs 2000 crores became nationalized.
Although the origin of central banking dates back to 1894, the art of the central banking had
incorporated new dimensions only during the 20th century. Central banking is in fact essentially a
20th century phenomenon (Shekhar, 2010). The Central bank of a nation is provided the
necessary autonomy, authority and responsibility of issuing tender currency which facilitates to
bring about uniformity in the circulation of liquidity in the economy. In layman language if the
focus of commercial bank is credit creation in the economy, the Central bank emphasizes to
control the credit. In the year 1991-92, The Government of India opened all the sectors
including banking sector towards the private players as well as foreign players apart from very

few strategic sectors such as Indian Railway, Defense, Atomic Energy. The Modern banking was
going through numerous changes fostering increased competition; hence the traditional inward
focus had to become more market oriented. The imperative is much more evident in transitional
markets. Owing to the opening up these markets to the external competition, transitional
economies including India faced stiff competition from the banks of developed countries (Kolar,
2006).
According to Dalvinder Singh, the responsibility of the bank supervisors is to keep a close
monitoring and improve corporate governance within the banking system. Bank regulators place
a formal responsibility on banks to protect the interest of number of legal stakeholders such as
depositors and regulators apart from central relationship between shareholders and management
(Singh, 2006). The four items which includes definition of scope and direction of bank, its
capital adequacy ratio, level of exposure to the market risk and degree of off balance sheet
operations are mainly monitored by the central bank of each nation. The system resiliency that is
the ability to recover both internal and external shocks whether cyclical or unexpected is function
of the level of control maintained by regulators (Maxwell, 1990).
Supervisory role of the Central Banks: Trust in policymaking institutions is an essential aspect
of good governance in democracy. Institutional trust, which implies ones prediction that
everybody can rely on benevolent and competent policies of a given institution is important to a
policy making body because its legitimacy and policy efficacy depend on it. If the common
perception of the citizens of the nation is that an institution is not enough trustworthy, they may
not adhere to its policy decisions or they may act with the purpose of undermining the authority
of the institution. The credibility of the policy making body comes under a question mark which
is not at all a good signal to the all stakeholders of the society (Kaltenthaler, 2010).

Over the past decade many countries have witnessed the changes in the architecture of banking
supervision. Often the institutional change was triggered by a banking crisis which hurt the
reputation of the supervisors. Sometimes after scanning the both global and national environment
policymakers have to rethink due to structural change in the financial industry which brought
about mergers between banks, brokerage companies and insurance players. The Glass Steagall
Act in 1933 can be used as ready reference where a bank cannot do simultaneously both
commercial and investment banking. Once the Gram Leach Belly Act repealed the Glass Steagall
act in 1999, under the same roof, a bank can offer commercial banking, investment banking as
well insurance and brokerage service to its clients. In one way, Gramm leach Belly act was
much more progressive and it paved the way of financial reengineering which created several
complicated high end financial instruments, similarly it was one of the major responsible factor
for the sub crime crisis where simultaneously collateral debt securities and credit default swaps
were sold aggressively without thinking about the ultimate consequence of such herd behaviour.
Nevertheless it is an ongoing debate whether the supervisory structure should be reformed and if
so in what direction. It can be said without any ambiguity that a flawless, efficient and effective
supervisory model can be created if regulatory independence, supervisory independence,
institutional autonomy and budgetary independence are free from the political interference and
bureaucratic hassles (Masciandaro, 2007).In India, private banks are participating in para
banking activities by creating subsidiary. For instance, ICICI bank is doing the core banking
activities where its subsidiary ICICI Direct is dealing with the brokerage business and its other
subsidiaries such as ICICI Prudential and ICICI Lombard are offering insurance services. Kotak
Mahindra Bank is offering core banking services, its subsidiary Kotak Mahindra Asset
Management Company is selling the mutual fund, Kotak securities is providing the brokerage

service. On the other hand HDFC is a holding company which is NBFC and providing finance
for housing development purpose. It is offering banking services by its subsidiary HDFC bank; it
is dealing the mutual fund by its subsidiary HDFC Asset Management Company, it is offering
insurance service by its subsidiaries HDFC Standard Life Insurance Limited and HDFC Ergo
General Insurance Company Limited. PSU banks are dealing with para-banking activities by
creating separate division. The State bank of India is offering core banking activities, SBI
Mutual fund is dealing with the business of asset management company, SBI life is playing in
Life insurance market. Still Indian banking sector is more or less quite conservative by nature as
it did not allow the banking company to do any other non- banking business. Similarly players of
any other sector except banking are not yet provided the banking licenses by RBI. As a result the
risk of money laundering as well as fund siphoning can be reduced to a significant extent. The
Parliament of India has approved the Banking Law bill on 18th December 2012 which could
eventually see many of Indias largest business houses return to banking sector from where they
were compelled to exit after the ex-Prime Minister of India , Mrs Indira Gandhi nationalized the
banks. The bill has created the provision that voting right in Private Banks will be confined to
the shareholders who have the ownership of at least 26% and voting right in Public Sector
Undertaking Banks will be restricted to the shareholders who have the ownership of at least 10%.
The minority shareholders can exercise their franchise only by referendum where opinions of the
shareholders are taken either in favour or against of any motion. Apart from these, according to
this new bill, RBI will have the power to supersede the boards of the bank to inspect the books of
accounts of the associate companies of the bank and RBI will have the power to inspect the
books of other subsidiaries of the bank with the concerned regulator. The bill allowed the State
owned banks to raise capital through right issue and the competitive commission of India will

10

regulate anti competitive practices and would also have power to approve the corporate
restructuring such as merger and acquisition (ETIG Database).
Earlier RBI used to follow the CAMEL model for supervising the banks. According to this
approach, emphasis was provided to the few parameters such as capital, asset quality of the bank,
management quality, earning quality or net interest margin of the bank, liquidity position of the
bank as well as sensitivity of the banks toward the market risk. Apart from CAMEL, offsite
monitory and surveillance system, consolidated financial statement and consolidated prudential
report, revised long form audit report were used as the tools of supervision by the RBI. A gradual
slow but steady and silent shift took place from CAMEL based supervision to risk based
supervision. The basic purpose of risk based supervision is to develop a risk profiling for each
bank. A typical risk profile document as mentioned by RBI incorporates CAMELs rating with
trends, detail description of key risk features captured under each CAMEL component, summary
of key business risks, SWOT analysis as well as sensitivity analysis (Yamanandra, 2003).The
risk based supervision provides major emphasis on risk where risk arises from the asset liability
mismatch in banking sector. A vital issue in the strategic bank planning is asset and Liability
Management (ALM).It is the assessment and management of financial, operational, business
functions which are endogenous by nature and management as well as mitigate different types of
risks which are exogenous by nature. The objective of ALM is to maximize returns through
efficient fund allocation given an acceptable risk structure. ALM is a multidimensional process,
requiring simultaneous interactions among different dimensions. If the simultaneous nature of
ALM is discarded, decreasing risk in one dimension may result in unexpected increases in other
risks (Tektas, 2009). The excessive off balance sheet exposure is another area of risk faced by
the banks.

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Emergence of Basel Frameworks and its importance: The major pillars of a bank comprises
of liquidity, profitability and safety. In the era of globalization, liberalization and privatization,
any nation cannot prosper so long it achieves sustainable increase in per capita income. The
satisfactory growth rate can be achieved only when the nation is able to generate adequate
investment. The source of investment is the adequate savings which usually come from both the
household as well as the corporate sector. The banking sector is the intermediary which can
convert the saving of the household and corporate into productive investment. Though the banks
are discharging several roles simultaneously, the major role played by the bank is credit creation
within the economy. Banks are creating loans and advances for the sake of their business. By
default, debtors are the asset for the bank. If a significant portion of the debtors are converted to
non performing loan, banks are unable to meet their liabilities such as paying the interest to the
deposit holders. Therefore the banks have to hedge their risk by adopting appropriate risk
management strategy. Unlike other banking liabilities, capital can be used to absorb losses.
Minimum capital requirements set a basic level of resilience against losses and help to protect a
bank against insolvency. Internationally agreed minimum standards for capital requirements
have existed since the first Basel Accord of 1988, Basel I. The objective was to create uniform
risk management policy across the globe. According to Basel I, it was decided that banks have to
maintain at least 8% capital adequacy ratio to hedge against the credit risk. The capital adequacy
ratio is interpreted as (tier I capital + tier II capital) / risk weighted assets. Tier I capital includes
equity capital as well as reserve and surplus. Tier II capital composes of revaluation reserve,
hybrid instruments, general provisions, subordinated debts etc. Though Basel I sets the criteria of
maintaining 8% capital adequacy ratio, RBI instructed all Indian banks to maintain at least 9%
capital adequacy ratio. Under Basel I, capital requirements for credit risk exposures are set

12

purely on the basis of the type of portfolio: a fixed risk-weight is applied to each type of
exposure, and banks are required to maintain a ratio of capital, after deductions, to total riskweighted assets of 8%. A portfolio of qualifying sovereign exposures attracts a risk-weight of
0%, exposures to banks, qualifying non-bank financial institutions are allotted a risk-weight of
20%, the retail mortgage portfolio is attached a weight of 50%, and corporate as well as
unsecured retail portfolios are assigned (such as credit cards) a weight of 100% (Benford, 2007).
Basel II norms came afterwards and in Basel II, there were three main pillars. The three pillars
include minimum capital requirement, mandatory disclosure and close

supervision. The

criterion of the minimum capital requirement means if the banks credit rating is
extraordinarily good, it can maintain lesser amount of capital than the stipulated benchmark. The
banks are instructed to disclose mandatorily its risk management strategies in depth on a
continuous basis to all of its stakeholders in its quarterly, half yearly and annual report which are
available in the public domain. The Central banks of each nation will have to perform the role of
watchdog and closely supervise whether all the banks are properly conforming to the norms of
Basel II. The another significant difference between the Basel I and Basel II is that Basel I was
focusing only on credit risk where Basel II emphasized on market risk and operations risk apart
from the credit risk. Market risk incorporate all the risks which are beyond the control of any
individual company or sector such as commodity and equity pricing risk, credit spreads, inflation
risk, interest rate risk, foreign exchange rate risk, risk from unforeseen contingencies such as
war, instability of the Government, external aggression and internal invasion as well the natural
calamities such as famine, flood, earthquake, tsunami etc. The concept of value at risk is used to
measure the market risk. Operations risk includes underperformance of the banks due to
inefficiencies of the employees, inability to capture and store the data, infrastructural inadequacy

13

of the bank offices, money laundering, Inadequate business continuity planning, improper
succession planning /talent shortage, faulty software used by the banks and server problem
which creates a major area of concern as it is an impediment in successful operation of the net
banking as well as the Core Banking Solution (CBS) . Basel II provided the necessary guidelines
to calculate the expected and unexpected loss incurred by a bank. Different financial jargons are
used for computational purpose of the quantum of loss a bank can incur. Some of the key
terminologies are probability of default, Loss given default, exposure at default. The Probability
of Default (PD) is the likelihood of a borrower defaulting on a contractual obligation. To
calculate the PD, the time horizon must be long enough to be meaningful and short enough to be
feasible given the data available. Several sequential steps are to be followed such as establishing
the time horizon, determining the measurement approach using the quantitative data such as
financial statements, ratios as well as qualitative information such as borrowers reputation,
equity prices, critically reviewing the available information, analyzing the published default
studies/ secondary data as well as successful use and implementation of transition matrices to
look at the way PDs change over time. Loss Given Default (LGD) is the estimated percentage of
loss which bank has to incur if default takes place and this loss can not be recovered. The
relationship between LGD and recovery rate are stated as LGD = 1- Recovery rate. Usually the
collaterals reduce the risk of an exposure and hence collateralized loans carry lower risk weights
than un-collateralized loans. The idle cash or deposit, gold, securities by sovereigns & public
sector entities carrying a minimum rate of BB-, banks and corporate securities are rated
minimum at BBB-, equities listed in major stock indices such as Dow Jones, Nikkei, Sensex etc
are considered as eligible collaterals. However the value of the collateral C is adjusted by
applying so called Hair Cut (H). The equation can be written as CA= C/( 1+H) Where CA=

14

Collateral Adjusted. The value of H will depend on the value of collateral. It varies from 0%
(cash), 4% (sovereign securities), 15% (gold) and 30% (eligible corporate securities). Exposure
at Default (EAD) is the maximum amount that a bank can lose in the event of a default.
Expected loss is the amount that a bank can expect to lose on average in the event of a default.
Expected loss is the product of probability of default, loss given default, exposure at default. In
the form of equation, it can be written as EL= PD x LGD x EAD. Unexpected loss/ unanticipated
loss are computed by subtracting expected loss from actual loss. UL= Actual loss Expected
loss.
Performance Measurement of the Bank: RBI has to supervise the performance of different
PSU banks, the old generation private banks, the new generation private banks as well the
foreign banks. There are multifaceted approaches for the performance evaluation of the different
banks, but hardly any standardized approach is prevalent. The performance of a bank can be
analyzed by the four prolonged approach which is composed of growth, size, sustainability of
operations and risk management. Growth incorporates growth rate in demand deposit, growth
rate in loan and advances, growth rate in core fee income, growth rate in operating profit, growth
rate in total deposit and growth rate in net interest income. Size incorporates volume and value of
demand deposit, loans and advances, Balance Sheet size of the bank, total number of branches
operating, total number of ATMs as well as total number of employees of the bank both in the
national and international level. Sustainability of the operation includes asset quality,
productivity and efficiency of the bank. Asset quality incorporates growth rate of Non
Performing Asset, NPA provision coverage and the ratio of net NPA to net advances.
Productivity is measured by cost to average assets ratio, operating profit per branch, operating
profit per employee. Efficiency is judged by cost to income ratio, ratio of operating profit to total

15

income, return on average assets, non interest income to total income, return on average net
worth, net interest income to average working funds, net interest income , the ratio of net interest
income to total average assets and cost of fund. Risk is measured by the capital adequacy ratio
and the ratio of Tier 1 capital to total shareholders capital (Roy, 2012). A new conceptual
dimension is identified to measure the risk of the bank which is known as Knock out ratio. The
knock out ratio is computed by the ratio of gross NPA to Tier 1 capital of the bank. A bank with
high knockout ratio indicates banks credit appraisal procedure is faulty for which non performing
loans are accumulated.
Subprime Crisis and Its Long Term Consequences: The entire globe had faced a financial
catastrophe due to the subprime crisis which took place in USA in the year 2008-09. The origin
of the crisis was some unscrupulous financial intermediaries who lend the fund to some nonqualified borrowers at a rate which was higher than the prime rate. Then the intermediaries
created a pool of mortgage based loan and they sold the mortgage based assets to a low risk
entity entitled Special Purpose Vehicle which was administered by a trustee. Thereafter the
intermediaries converted the mortgaged based asset into collateral debt obligation which was
sold to the different banks and financial institutions. When the real estate bubble busted, the
banks and financial institutions went to croak the properties of the subprime debtors who failed
to repay their loan. The price of the real estate properties went down to a significant extent due to
abnormal selling pressure. The several Western financial institutions including Merrill Lynch,
Lehman Brothers, AIG, and Goldman Sachs were suffering from liquidity crisis. Both the rating
agencies and the sophisticated mathematical risk management models severely underestimated
the risks associated with such a strategy and the bonus culture and high leverage greatly
encouraged the tendency of excessive risk taking by rewarding chance based apparent success

16

but not penalizing the failure (Holland, 2010). Though neither any Indian company had subprime
exposure nor any Indian company went for liquidation, still Indian export which includes
agricultural product, cotton, textile, diamond and jewelry etc suffered a lot due to excessive
withdrawal of fund by Foreign Institutional Investors from the Indian stock market. The Sensex
went down from 21000 points to 7500 points within a couple of months. The bloodbath
experienced by Indian stock market created liquidity crunch situation which resulted adverse
effect in different Indian companies such as layoff, salary cut and recruitment freeze. If the root
cause of this subprime crisis can be analyzed, it can be concluded without any ambiguity that
credit risk was overpriced and liquidity risk was not taken into account with due considerations.
The liquidity problems commonly happen because of failures in the management of funds or
unfavorable economic conditions which lead to unpredictable liquidity withdrawals by the
depositors. Indeed, maintaining a robust liquidity management is very challenging and difficult
in the current competitive and open economic system with strong external influences and
sensitive market players (Ismal, 2010).
Emergence of Basel III: Basel III is a recent development in the area of banking sector where
major impetus has been provided towards the liquidity risk. The Macro Economic Assessment
Group was established in February, 2010 by the chairs of the financial stability board and Basel
Committee on Banking Supervision to coordinate an assessment of macro Economic
implications. Basel III emphasized on tier I capital. The important element of BASEL III is an
increase of the minimum common equity requirement from the current 2% level to 4.5%.
According to the BASEL III norms, banks are required to hold a capital conversion buffer
comprising 2.5% of common equity. The countercyclical buffer would be as large as 0- 2.5%
position of risk weighted assets. Reserve and surplus should not be less than 2%. Therefore for
17

successful implementation of the BASEL III, banks have to maintain at least 11.5%

capital

adequacy ratio. The capital adequacy ratio should be in the form tier I capital. The successful
implementation of Basel III will provide a common platform or a common level playing field for
all banking players both in the national as well as international level in future. Basel III does not
take into account the tier II capital. Basel III focuses on the Liquidity Coverage Ratio (LCR) and
net stable funding ratio. LCR ratio aims to ensure that a bank maintains an adequate level of high
quality assets that can be converted into cash to meet its liquidity needs for a thirty days time
horizon under an acute liquidity stress scenario. Net stable funding ratio is defined as available
stable funding divided by required stable funding.
Corporate Governance in Banking: The sound corporate governance becomes a critical
success factor in any company when ownership deviates from control. Smt. Pratibha Patil, the
former Honourable President of India opined that Corporate Governance is about working
ethically and finding a balance between economic and social goals. It includes the ability to
function profitably while obeying laws, rules and regulations during the Lakshmipat SinghaniaIIM Lucknow National Leadership Awards ceremony 2007, at New Delhi, on 12th February,
2008. The corporate governance mechanism is much more crucial in banking sector as if a bank
goes for bankruptcy, apart from the shareholders and employees of the bank, the depositors of
the bank who have deposited their hard earned money will become financially insolvent.
According to the corporate governance rating organizations, the Chief Executive Officer of the
organization and the Chairperson of the board should not be the same person. But in case of
Indian PSU banks, it is a common practice that the same individual is holding the post of
Chairperson and the CEO who is known as Chairperson cum Managing Director (CMD) of the
Company. The international consensus in preserving the soundness of the banking system has
18

highlighted the following as prime necessities such as effective risk management system,
adequate capital provision, sound supervision and regulation, transparency of operations,
conductive public policy intervention and maintenance of macroeconomic stability, existence of
appropriate oversight by senior management, independent and qualified directors who are not
subject to undue influence from management or outside concerns, careful attention to the audit
report prepared by the internal and external auditors as an important control function
,establishment of strategic objectives and a set of corporate values which are required to be
communicated to the entire banking reorganization (Bansal, 2005). Section 12 of the Prevention
of the Money Laundering Act, 2002, casts certain obligations on the banking companies with
regard to preservation and reporting of customer account information. Each bank has to furnish
information of transactions to the director of the Financial Intelligence Unit of India within the
prescribed time, where the Principal Officer has reasons to believe that a transaction or a series
of transactions are integrally connected so as to prohibit the provisions of this section. The
information should contain the nature of transaction, the amount of transaction and the currency
in which it was denominated , the date on which the transaction was conducted and the parties to
the transaction. The Cash Transaction Report (CTR) should be submitted on a fortnight basis by
branches to their circle offices. For the first fortnight ending 15th of the month the report shall be
sent before 20th and for the second fortnight the report is to be sent before 5th of the next month.
Individual transaction below Rs 50000 may not be included. The Suspicious Transaction Report
(STR) should be submitted on a fortnight basis by branches and circle offices where any
transaction whether cash or non cash or a series of transactions integrally connected is of
suspicious nature. The branch manager should record his or her reasons in the register for
treating any transaction or a series of transactions as suspicious. The Counterparty Currency

19

Report shall be submitted as and when any transaction related to deposit of counterfeit currency
notes or defrauding the bank by forged high value securities etc take place (Fernando, 2012).
A significant number of players of Indian banking sector still remain under the control of the
Government (PSU banks) despite the strong wave of globalization, liberalization and
privatization and entrance of private and foreign banks in the arena. The major shareholding of
the public sector undertaking banks are lying with the Government. The reasons for such
ownership may include solving the severe informational problems inherent in developing
financial systems, aiding the development process or supporting the vested interests and
distributional cartels. The Basel Committee has underscored the need for the banks to establish
the strategies and to become accountable for executing as well as implementing them (Dhar,
2010). NPA accumulation is the major characteristics of PSU banks due to political intervention
and lack of aggressive profit motive. Though majority of the Indian banks both private and
public sector undertaking banks are maintaining much higher capital adequacy ratio than the
global prescribed benchmark of Basel I and Basel II norms, the Union Finance Minister of India
Mr. Pranab Mukherjee emphasized more and more on capital infusion to the PSU banks in the
union budget for the financial year 2010-11, 2011-12 and 2012-13 just to ensure that tier I capital
adequacy ratio of the PSU banks should be enhanced to 8% itself. In a recent study of corporate
governance in banking, a panel of the Basel Committee on Banking Supervision reiterated the
conventional view that the board of directors are essential elements of "checks and balances" in
the "organizational structure of any bank". The panel listed oversight by the board of directors as
one of the four important forms of oversight, together with "direct line supervision", the role of
professionals detached from the day-to-day operations, and "independent risk management,
compliance and audit functions". A similar assumption underlies the exchange rules requiring
20

predominantly independent boards issued in 2003. Yet, there is little evidence that the directors
of major banks acted to mitigate the excessive risks leading to the 2008 financial crisis, or even
assumed responsibility for bank losses (Murphy, 2011). Although the mechanisms of deposit
insurance and lender of last resort have been quite helpful in preventing a deepening of the
financial crisis during 2008-09, prudential supervision, capital requirement and the adequate
mechanism for orderly bail-out did fail. The prudential supervision failed to identify the high
levels of risk and the sources of relevant risks (liquidity risk). The capital requirements were
based on incorrect risk measurement models that failed to take into account the risks associated
with partial securitization, over the counter operations and the use of mark-to-market accounting
rules without adequate provisioning. Finally, the bail-out or liquidation decision was the
inefficient result of a lengthy bargaining process with the banks stakeholders. The inadequacy of
the safety net was clear once the pro cyclicality of capital regulation (whether Basel I or II) was
established with its consequences; the fact that banks were led to liquidate their assets at a lower
price. In addition, the transfer of banking risks to the non-banking financial industry, thus
creating a so-called shadow banking system has led to a situation where banking risk has
escaped the regulatory authorities. Finally, the market discipline enthroned in the Basel II third
pillar, as a key principle, did not produce the expected results (Freixas, 2010). The board
composition refers to the distinction between inside and outside directors and the percentage of
outside directors on the board. Although the inside and outside directors have their respective
merits and demerits, most researchers favour outside dominated boards. Outside directors
provide superior performance benefits to the firm as a result of their independence from firms
management. They can bring to the board a wealth of knowledge and experience, which the

21

companys own management may not possess and they can increase the element of
independence and objectivity in boards strategic decision-making.
Credit Control Policies of the Central Banks: The Central bank has the supreme authority to
decide about the monetary policy of a nation. The liquidity control mechanism followed by the
RBI consists of both qualitative and quantitative policy. Usually the quantitative controls are
alternatively termed as direct control which is equally applicable to the all sectors. The
instruments of the quantitative control includes Bank Rate, Open Market Operations (OMO),
Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), Repurchase Offer (REPO) and
Reverse Repurchase Offer(Reverse REPO). When the purchasing power of the citizen of the
nation is suffering from high inflation, the RBI will raise Bank Rate, CRR, SLR, Repo and
Reverse Repo rate to reduce the credit creating capacity of the commercial banks.
Simultaneously the RBI will prefer to sell their securities to the commercial bank so that excess
liquidity of the bank can be reduced which will automatically curb the lending power of the
banks. When the Government of India smells the rat of recession, RBI reduces the bank rate,
CRR, SLR, repo and reverse repo rate to boost the credit creating ability of the banks. Similarly
RBI prefers to buy the securities from commercial banks to enhance the liquidity position of the
commercial banks. The qualitative control or indirect control implies selective control as it is not
applied to all the sectors. Selective control includes regulation of margin requirement, moral
suasion and regulations of consumer credit. If the inflation rate is quite high, RBI will raise the
margin requirement which will automatically reduce the lending power of the bank. Similarly
RBI will make an appeal to all the commercial banks not to accept those collaterals which were
accepted earlier. Enhancing the standard of collaterals, by default RBI will be able to reduce the
circulation of money within the economy. Another stringent action RBI can take by reducing the
22

loan ceiling for each listed items and decreasing the number of installments within which debtors
have to repay the entire loan. On the contrary, in the anticipation of recession, depression or
liquidity crunch in the coming future, RBI reduces the margin requirement, increases the credit
ceiling as well as make a moral appeal to the commercial banks to accept comparatively inferior
quality collateral just to ensure enough liquidity flow in the economy.
Sterilization Policy of the Central Bank: RBI plays the crucial role of sterilization mechanism.
In the era of globalization, India is following flexible exchange rate policy where the exchange
rate is market determined but the government reserves the provision to intervene in extreme
cases. It is known as dirty float mechanism. When there is an excess inflow of the foreign fund in
the economy as Foreign Institutional Investors (FIIs) are penetrating into Indian Market in order
to enjoy the interest rate arbitrage, as an immediate effect, there will be an appreciation of the
home currency. If the home currency appreciates beyond a certain level due to continuous
buying pressure, exporting sectors are likely to suffer a huge jolt. RBI usually intervenes in the
process by buying the dollar and selling rupee. Technically it is injection of the liquidity in the
body of the economy by RBI to stop further appreciation of home currency. To hedge the risk of
inflation, RBI issues the Government securities such as treasury bills which are known as Market
Stabilization Schemes. These T bills are held to maturity in nature as they are not traded in the
secondary market. These bills are issued to take away the excess liquidity from the economy. On
the other hand, once there is doom and gloom situation in the economy, FIIs are pulling out
their funds from the domestic market. Due to excessive selling pressure, home currency
depreciates with respect to foreign currency which creates a devastating effect in the importing
sector. If the foreign currency depreciates beyond a certain level, current account deficit of the
nation will be wider. Under these circumstances, RBI comes as rescuer by selling the dollar and

23

buying the rupee. This process is known as absorption of the liquidity from the economy. The
injection and absorption of the liquidity to the economy by RBI is known as sterilization process
which actually immunes the nation against the volatility of exchange rate to a significant extent.
Pros and Cons of Expansionary Monetary Policy: Expansionary fiscal policy alone cannot
enable to grow the economy up to the desired level. Only the fiscal stimulus is unable to
appropriate the entire growth potentiality of the nation to the extent of the Simple Keynesian
Macro Economic Multiplier. For example if the Government is increasing its expenditure on
goods and services, national income should grow in the proportion of the Simple Keynesian
Government Expenditure multiplier value. Once income increases, transaction demand for
money also increases. If the aggregate supply for money remains constant, aggregate demand for
money has to remain unaltered to ensure money market equilibrium. If transaction demand for
money goes up, speculative demand for money has to go down. As a result, interest rate will go
up which will have contraction effect on private investment. Therefore income will go down
which is termed as crowding out effect. Simultaneously expansionary Fiscal Monetary Policy
mix can overcome the crowding out effect and economy will be able to achieve the desired
benefit as per the simple Keynesian Macro Economic model. The Expansionary monetary policy
can provide new dimension of the growth in the economy if the Government uses the increased
money supply in financing the employment generation project such as road and building
construction projects. This will automatically increases the employment of nation. As the
purchasing power of the common mass goes up due to productive employment generation,
aggregate consumption demand goes up. If the aggregate supply remains unaltered, price will go
up due to excess demand or scarcity factor. Since price goes up to a significant extent, producer
will be motivated to produce and supply more and more to book the maximum profit. In order to

24

produce higher amount of output, they require more factors of productions which will increase
employment opportunity further. Therefore, all the macro economic variables such as
employment, income, output and price will go up. This is known as pump priming effect which
implies growth rate can be enhanced by pumping more liquidity in the economy. Risk of
inflation is prevalent when the Government is exercising the pump priming mechanism. In a
developing nation like India, a mild controllable dose of inflation should be injected in the body
of economy. Despite all the evils, inflation has one blessings, it enhances the aggregate demand.
The phenomenon can be properly described by the Philips curve. Short run Philips curve shows
inverse relationship between inflation rate and unemployment rate. If inflation rate goes up,
unemployment rate has to go down and aggregate demand is stimulated. In order to enjoy the
blessings of inflation, the nation has to ensure that infrastructural facility is adequately
supportive for industrialization. The basic infrastructure includes communication and
transportation system such as road transport, transportation by railway, sea route and air as well
as adequate power generation. In the absence of basic infrastructural facility, economy will have
to bear only the worst effect of inflation. Under this circumstance, the commonly used jargon is
stagflation where higher rate of inflation is accompanied by stagnation in growth rate. After the
European nations went for sovereign crisis and the announcement of Fiscal cliff by the USA
President Barrack Obama, there is an extraordinary pressure on the RBI for interest rate cut from
the corporate lobby. Though RBI has reduced CRR, SLR, Repo, Reverse Repo rate, but still
corporate India is not satisfied with the action taken by RBI. Though it is really difficult to meet
both the end still RBI has to take the appropriate decision by striking a balance between growth
potential of the nation and the inflation rate. In an emerging economy like India with 28 States
and 7 Union Territories, Wholesale Price Index (WPI) number is used as the standardized

25

measure of inflation though often it does not provide the fair picture. Often it has been seen that
Cost of Living Index number is quite high though WPI is low in comparison to that. After the
deregulation of the price of petrol, diesel and withdrawal of subsidy from LPG, the inflation rate
is expected to increase in upward vicious circle. Under this circumstance, RBI prefers to opt for
wait and see strategy rather than taking a hasty decision of immediate rate cut. But RBI is not
the only Central Bank which is stalling rate cut. The below mentioned chart validates the stance
taken by RBI.
Name of the
Central Bank
Bank of
Japan

Bank of
Korea

United States
Federal
Reserve

European

Action

Japans incoming prime minister Shino Abe had suggested that he would look at the
changing law that governs the Central Bank, in an attempt to have more control over it to
ensure that Bank of Japan helps the Governments efforts to boost growth. He said that he
would set an inflation target as high as 3% and even suggested that Japans Central Bank
should print Unlimited Yen to help counter falling prices. Another of Abes proposals
has been to get the bank of Japan to take more pressures to help revive the economy,
including the Government bonds.
On December, 2012 the bank of Korea kept interest rates unchanged at 2.75% after
cutting rates in July and October. South Koreas economic data has given mixed signals
and a rapid rebound in growth is unlikely, the Governor Choongsoo Kim said after the
banks unanimous decision. At the same time, the nation is poised for a moderate export
led recovery and inflation will remain low, the BoK said in a statement, bolstering the
view that policy action will remain in hold.
The Federal Reserve announced third round of bond purchases in the month of
September, 2012 which is known as (Quantitative Easing) QE3. Federal Open Market
Committee once again rolled out the unconventional policies to bolster the economic
growth of USA which was less than 2% in the second quarter of 2012-13. Fed is
committed to an open-ended policy of ease money, buying the Government bonds, and
mortgage based securities to keep the interest rate at a low level in the long run in order
to stimulate the economic recovery. The committee agreed to purchase additional
agency mortgage at a pace of $ 40 billion. The committee will also continue through the
end of the year its programme to extend the average maturity of its holding of securities
as announced in June and it is also maintaining its existing policy of reinvesting the
principal payment from its holding of agency debt and agency mortgage backed
securities in agency mortgage based securities. These combined action which will
increase committees holding of long term securities by about $ 85 billion each month
through the end of the year. On December 14, the US federal Reserve also decided to
keep its benchmark short term interest rates near zero through at least mid 2015.
On December 7, 2012 The ECB Kept rates unchanged at a record low of 0.75% in line
26

with expectations. The status quo on the policy front reflects the European Central Banks
dilemma regarding uneven monetary transmission loss across the euro zone. The ECB
would like to see improvement in monetary transmission before embarking on the path of
future cuts.
Reserve Bank On 18th December, 2012, The Reserve Bank of Australia in its monetary policy meeting
of Australia
cut the cash rate target by 25 basis points to 3% in line with market expectation.
Bank of
On December 4, 2012, The Bank of England maintained status quo on interest rate at
England
0.5% and maintained asset purchases at 375 billion pounds.
Central
Banks

Source: ETIG data base

Conclusion: It is a universal saying that change is the only constant in every sphere of life. Same
is applicable for RBI also. Majority of the Indian banks have more or less successfully
implemented Basel II norms. One of the pillars of Basel II is emphasizing on minimum capital
requirement which implies if the credit rating of bank is outstanding, they can maintain lesser
capital than the stipulated norms. Earlier credit ratings of the banks are being done by the
external credit rating agencies such as CRISIL, ICRA etc. According to the modern IRB based
approach, banks are asked to develop its own internal credit rating system. Few Indian banks
have already developed their own internal credit rating framework such as SBI, ICICI bank and
HDFC bank. But the majority of

Indian banks are striving to implement this IRB approach.

More over Indian banks are passing through a critical phase as this is the conversion phase from
Basel II to Basel III.

The implementation of Basel III requires huge amount of capital.

Simultaneously maintaining an extraordinarily higher capital adequacy ratio is also not the
proper solution. Nobody can deny the fact that maintenance of certain amount of capital
adequacy ratio is required as it hedges the risk against liquidity crisis. Similarly it is equally true
that an extremely high capital adequacy ratio reduces the credit creating capacity of the bank
which creates an adverse impact on the profit margin of the bank. Another tendency has been
observed that in order to clean their balance sheets, banks are transferring their non performing
asset to its Corporate Debt Restructuring (CDR) cell and CDRs are restructuring the loan by
lowering the interest rate and enhancing the loan repayment schedule without addressing the
27

fundamental problems. In order to stimulate capital market, the RBI is ultimately compelled to
reduce CRR, Repo and Reverse Repo rate by 25 basis points on 29th January 2012 which will be
effective from the fortnight beginning February 9, 2013(source: Economic Times on line
database as on 29.1.2013)

The Repo rate has been reduced to 7.75%, Reverse Repo rate has

been reduced to 6.75% and CRR has been reduced to 4% which enhances the probability that
inflation rate may go up in near future. Therefore the RBI has to simultaneously discharge
various roles such as role of supervisor, monitor, liquidity controller as well as policy maker in
such a way so that maximum benefit can be provided to all stakeholders of the nation.
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