FINANCIAL SECTOR REFORMS

Prof. Mishu Tripathi Assistant Professor-Finance

Changing face of India

1991 Indian Economic Crisis to India being the fourth largest economy in the world Exponential growth in the Indian Banking Sector Innovative practices adopted by Financial Sector participants Prudent practices of the Central Bank in immunizing India from the rest of the World

Are reforms required?

Despite impressive quantitative achievements in resource mobilization and extending the credit reach, several distortions have, over the years crept into financial system especially in respect of allocation of financial resources. The productivity and efficiency of the system have suffered, its profitability has been eroded and its portfolio quality has been deteriorated. Customer service has been poor, work technology remains out-dated and transactions costs are high. YES / NO ???

Objective of the Reforms

The object of reform should be not only to correct the present financial weaknesses but also seek to eliminate the causes, which have brought about this situation. Ex. Financial WeaknessesMoney Laundering Ex. Causes Improper or no KYC To make the economy more competitive and efficient.

Factors contributing towards weaknesses of a bank

The impact of policy induced rigidities such as an excessive degree of central direction of their operations in terms of investments, credit allocations, branch expansion and even internal management aspects of business. There has been elements of political interference which has prevented the institutions operating on the basis of their commercial judgment and in the framework of internal autonomy, resulting into making the Indian banks non competitive and non innovative

First steps towards a bright future

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 and landmark Committees were set up under the chairmanship of M. Narasimham (Ex-RBI Governor) in 1991 & 1998.

Narasimham Committee I and II

The first Narasimham Committee (Committee on the Financial System - CFS) was appointed by Mr. Manmohan Singh as India's Finance Minister on 14 August 1991 The second Committee (Committee on Banking Sector Reforms) was appointed by Mr. P. Chidambaram as Finance Minister in December 1997

Narasimham Committee-I Report on Financial Sector Reforms in India

Salient Features of the Committees Recommendations Were

Phased Reduction of Statutory presumption SLR (SLR presently reduced to 24%) to be reduced to 25% CRR to be reduced to 10% (CRR reduced to 6% recently) So that funds of banks are deployed by them in more remunerative way.

Salient Features of the Committees Recommendations Were

Interest rates on CRR balances Payment of interest on eligible balances i.e. cash balance above the basic minimum of 3%. Interest on eligible balance @4% to be paid

Salient Features of the Committees Recommendations Were

Phasing out of directed Credit programme Priority sector to be redefined. (small, tiny sector, village and cotton industry, rural artisans and other weaker sectors etc.) The target should be fixed at 10% of aggregate credit.(Government did not accept the recommendation to reduce the level of primary sector lending from 40%, sector was enlarged)

Salient Features of the Committees Recommendations Were

Interest rate deregulation Existing interest structure on loans and deposits is very complex and should have some market orientation (Bankers are given freedom to have own reference rate known as PLR. Fix rate within a band over PLR)

Salient Features of the Committees Recommendations Were

Capital adequacy norms Minimum 4% CAR in relation to risk weightage assets by March 1993. BIS standard of 8% to be advised by March 96.(RBI Implemented CA Norms. Only two banks UCO and Indian bank were able to achieve the norm of 8%)

An adequate capital fund is needed to bring about Solidarity in the system  Scope of investment  Operations efficiency  Ultimate strength of bank

Salient Features of the Committees Recommendations

Income Recognition Evaluation of assets on their realizable values Banks & FIs to adopt uniform accounting practices for income recognition and provision against bad and doubtful debts. No income to be recognized in the accounts in respect of NPAs asset would be NPA if interest on such asset remains due for the period exceeding 180 days.

INCOME RECOGNITION, ASSETS CLASSIFICATIONS AND PROVISIONING

The committee recommended that a proper system of income recognition and provisioning is fundamental to the preservation of the strength and stability of the banking system. A proper asset classification will, however, have to precede this exercise.

INCOME RECOGNITION, ASSETS CLASSIFICATIONS AND PROVISIONING

RBI had prescribed that all advances of a bank should be classified under the following Health Codes: Code No. Title 1. Satisfactory 2. Irregular 3. Sick: viable/under nursing 4. Sick: Non viable/sticky 5. Advances recalled 6. Suit-filed accounts 7. Decreed debts 8. Debts classified by banks as bad/doubtful

 As per the guidelines prevalent at that time, RBI directions were that in respect of advances covered by health Code 5 to 8, interest income should not be recognized until it is realized. At that time international practice was that an asset is treated as non performing when interest is overdue for at least two quarters. In respect of such non-performing assets interest is not recognized on accrual basis but is booked as income only when actually received. The committee recommended that a similar practice should be adopted by Indian banks.

Date of NPA: Earlier an asset was classified as NPA on the date of asset classification exercise undertaken at half-year ends. But now a borrower account can become NPA on any day during the year based on 90day delinquency norm. Hence the date of NPA is 91st day from the due date of interest and /or installment of principal remained unpaid.

 The committee was of the view that for the purposes of provisioning, banks and financial institutions should classify their assets by compressing the health code into following broad groups: 1. Standard 2. Sub-standard 3. Doubtful and 4. Loss

1. Standard assets are those where there are no over dues. 2. Sub-standard Assets would be those, which exhibit problems and would include assets classified as non-performing for a period of not exceeding two years. 3. Doubtful assets are those non-performing assets, which remain as such for a period exceeding two years and would also include loans in respect of which installments are overdue for a period exceeding two years. 4. Loss assets are accounts where loss has been identified but the accounts have not been written off.

Salient Features of the Committees Recommendations

Loan Recovery Special Recovery Tribunals to be set up.(Creation of recovery tribunals for loan a/cs with outstanding balance Rs.10 lakh or above. 8 tribunals and an Appellate tribunal in Mumbai were established up to March 1998)

Salient Features of the Committees Recommendations

Taking doubtful Debts Asset Reconstruction Fund (ARF to be created to take over bad debts & Balance sheet is to be made clean)

Salient Features of the Committees Recommendations

Restructuring of Banks 8 10 nationalized banks to create 3-4 large banks of international level- universal banking (No progress expect New Bank of India merged in PNB 1993)

Salient Features of the Committees Recommendations

Entry to private banks No further nationalization of banks No difference in treatmentofPublic & Private Banks. (Banking Resolution Act 1994 was passed to permit private sector to enter into banking field. RBI gave licenses to 9 private banks to start their banking functions in India(April 1994)

Salient Features of the Committees Recommendations

Branch licensing be abolished to be left to the individual banks. Foreign Banks Foreign Banks be allowed to open offices in India either as branches or subsidiaries. 19 new foreign banks with 47 branches were allowed (March 1998).

Salient Features of the Committees Recommendations

Supervision of Banks Indian banking system is over-regulated and over administered. Dual control by RBI and Ministry of Finance should end.

Salient Features of the Committees Recommendations

The public sector banks with profitable operations should be allowed to tap the market for enhancement of their share capital Subscribers to the issue could be mutual funds, profitable PSUs and the employees of the institutions besides general public

Narasimham Committee-II Report on Financial Sector Reforms in India

Autonomy in Public Sector Banks (PSB)

1. Recruitment procedures, training and remuneration policies of public sector banks be brought in line with the best-marketpractices 2. Reduction in GOI equity in PSBs to 33% 3. Review of functions of banks boards with a view to make them responsible for enhancing shareholder value

Role of the Central Bank

Segregation of the roles of RBI as a regulator of banks and owner of bank After-effects: RBI decided to transfer its respective shareholdings of public banks like State Bank of India (SBI), National Housing Bank and National Bank for Agriculture and Rural Development to GOI. Subsequently, in 2007-08, GOI decided to acquire entire stake of RBI in SBI, NHB and NABARD

Stronger Banking System

Merger of large Indian banks to make them strong enough for supporting international trade 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 Large banks should merge only with banks of equivalent size and not with weaker banks

Non-Performing Asset (NPA)

Creation of Asset Reconstruction Funds or Asset Reconstruction Companies NPAs to be brought down to 3% by 2002 Independent loan review mechanism to be undertaken After effect: Introduction of a new legislation which was subsequently implemented as the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI)

SARFAESI
The Act is a major step in financial sector reforms. It has brought a legal framework for the following important activities in the credit market: 1. Securitization of financial assets 2. Reconstruction of financial assets 3. Recognition of any interest created in the security for due repayment of a loan a security interest, irrespective of its from and nature but when it is not in the possession of the creditor

4. Power to enforce such a security for the realization of money due to banks and the financial institutions in the event of default, without the intervention of Court 5. Enabling provisions for the setting up a central registry for the purpose of registration of transactions of securitization, reconstruction, reconstruction and the creation of security interest.

Capital Adequacy and Asset classification

The capital adequacy ratio to 9% by 2000 and 10% by 2002 and have penal provisions for banks that fail to meet these requirements Govt. guaranteed advances which has turned sticky should be classified as NPAs General provision of 1% in std. assets to be introduced. Banks and FIs to avoid practice of ever greening

Other recommendations
Specialize in retail, agriculture, exports, SSI and corporate sector To understand the growing interdependence of various markets and develop necessary expertise More reliance on non fund business like advisory & consultancy services, guarantees and custody services

Continued
To move away from excessive concentration of asset Management and adopt general approach of Asset Liability Management Need for public sector banks to speed up computerization and focus on relationship banking