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Aims & Objectives National Centre for Theoretical and Applied Economic Research
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    • “Banking Sector Reforms-Looking Ahead”-Background Papers for Seminar, 11th June, 2005

     

     

    “Banking Sector Reforms-Looking Ahead”-Background Papers

    While opinions vary on the date of commencement of Economic Reforms- whether it started with the incremental reforms and liberalization policies of Rajiv Gandhi in the eighties or with the Narasimha Rao – Manmohan Singh initiatives of gradually opening up of the Indian economy to the global forces in the nineties, there is consensus that the financial and banking sector reforms commenced in the nineties.

    The Philosophical Base
    The philosophical basis of the economic reforms programme was set out in 1992 by Sri.P.V.Narasimha Rao in his preface to the Eighth Five Year Plan “The Eighth Plan is being launched at a time of momentous changes in the world and in India. The international political and economic order is being restructured everyday and as the Twentieth Century draws to a close, many of its distinguishing philosophies and features have been swept away. In this turbulent world, our policies must also deal with changing realities. Our basic policies have stood us in very good stead and now provide the opportunity to respond with flexibility to the new situation, so that we can work uninterruptedly towards our basic aim of providing a rich and just life for our people.” The then Prime Minister proceeded to point out that, “there is today recognition that in many areas of activity, development can be best ensured by freeing them of unnecessary controls and regulations and with drawing state intervention. At the same time, we believe that the growth and development of the country cannot be left entirely to the market mechanism. The market can be expected to bring about “equilibrium” between “demand” backed by purchasing power and “supply”, but it will not be able to ensure a balance between “need” and “Supply”. Planning is necessary to overcome such limitations of the market mechanism. Planning is essential for macro economic management, for taking care of the poor and the downtrodden, who are mostly outside the market system and have little asset management. It is thus not a choice between the market mechanism and Planning: the challenges are to effectively dovetail the two so that they are complementary to each other.”

    Dwelling on state and market interface, by Dr.C.Rangarajan explained in his Convocation Address at the University of Hyderabad , that “In the 1950s  and 1960s  , the dominant view in economic literature was that Government must play a role in correcting ‘market failures’ in the area of  allocation of resources over time, because of the ‘myopic’ nature of market participant , four decades of development experience world over has shown that there can be “government failures” as well , resulting not only in economic losses due to misallocations of resources arising from faulty investment decisions but also from diversion  of resources to rent seeking activities because of the very regulations themselves. Dr.Rangarajan further has observed that , “ if there is a lesson to be drawn from the development record of the last four decades, it is that there can be both “ government failure “ and market failure “ and the critical issue is not so much the presence or absence of the state intervention but the extent and quality of that intervention.” (Asian Economic Review Volume 42 Issue No. 1, April 2000). We may have to keep in view, the philosophic basis and historical experience while assessing the outcome of the financial and banking sector reforms, which enabled the Indian Economy to regain a measure of strength and stability.

     

    Banking Sector Reforms
    Of the various sectoral packages in the Economic Reforms Agenda covering fiscal reform, Industrial Policy Reform, Trade Policy Reform and Financial and Banking Sector Reform, by far the most far reaching changes impacting on the economy have been in the financial and banking sectors. The road maps for financial and banking sector reforms were laid by the Reports of the Committee on Financial Systems (1991), and the Committee on Banking Sector Reform (1998)  both chaired by Sri M.Narasimham , a financial administrator with deep domestic experience and vast international exposure. The High level committee on Balance of Payment headed by Dr. C.Rangarajan and a number of committees set up by the RBI made valuable recommendations on the changes in the financial sector and the banking system. Reforms were designed to ensure that the changes  were calibrated and secquenced  to meet the specific requirements of the various subsectors of the Indian Economy and could be carried out without affecting continuity of operations of the institutions in these vital sectors. The introduction of prudential regulations and prescription of norms for Capital Adequacy, Asset Quality, Management Earnings, Liquidity and Systems Control (CAMELS) for the banks reinfused a degree of discipline in the banking system. Issues of organization and management, systems improvement, human resources development and autonomy of operations were also covered in the report.It must however be noted that while not all the recommendations of the Committees were acted upon by the Government of India, there was a significant measure of political consensus in implementing the recommendation with emphasis on change with continuity and complementarity of measures taken in different sub-sectors of the economy.

    The calibrated change in the Indian financial and banking sectors came at a time when  emerging market economies allowed themselves to be rapidly drawn into the fast changing global financial systems, and even paid a high price. That the Indian economy was saved the pains of a crisis like those faced by the East Asian Economies is largely attributable to the circumspection, foresight and measured response displayed by Sri.Narasimham and other experts though some influential quarters were indeed impatient about the pace of change advocated and witnessed in the nineties. The Indian Economy was successfully steered out of the turbulent waters of the nineties.
     

    A decade and more later we now have the opportunity to not only assess the outcome of the earlier reforms, but also look ahead and prepare the nation and the economy for further changes.
    Data published by the RBI indicate the dimensional growth of banking services during the seventies and the eighties and highlight the continuing tempo of deposit growth even in the nineties.  Between 1969 and 1991, the number of bank officers increased from 8187 to 61724, the deposits of scheduled commercial banks from  Rs.4822 crores to Rs.200568 crores and credit from Rs.3467 crores to Rs. 124203 crores. The nineties witnessed a slow down in branch expansion particularly after 1995-96, taking the number of bank officers to 67221 by September 2004.  The period witnessed phenomenal growth in deposits further to Rs.1567251 crores and in credit to Rs. 939145 crores. The credit deposit ratios of 71.9 in 1969, 61.9 in 1991 and 59.9 in 2004 called for a closer look at the trends in the banking sector. This revealed  re-emergence of urban centric nature of banking, persisting regional disparities in distribution of bank credit, sharp reduction in the credit shares of agriculture and small scale industries and inadequate credit to informal sectors. The changing profiles of various bank group-Public Sector Private Sector and Foreign Banks provide clues to the nature of changes following banking sector reforms.

    The Economic and Political Weekly  described the recent developments as ‘metamorphic changes in the financial system.’ and has observed that “the Indian Financial System and its structure consisting of institutions, instruments, markets and public policies guiding and regulating them are expanding at a phenomenal pace nursing rapid diversification and undergoing metamorphic changes.” (EPW, March 19th, 2005).

    Recent Performance
    The aggregate deposits of scheduled commercial banks grew by 13.4 % in 2002-03 17.5 % in 2003-04 and 14.1% in 2004-05 and bank credit increased by 16.1 % in 2002-03  15.3 % in 2003-04 and 26% in 2004-05, and investments have also increased. Though the prevalent low interest rates resulted in lower income growth for the banks, there is a decline in gross and net non-performing assets. The gross NPAs declined from 4 % of total assets in 2002-03 to 3.3 % in 2003-04 and net NPAs from 1.9 % to 1.2 %. There are sector-wise variations in NPA improvements. Capital adequacy ratios also showed improvement. The ratio of capital to assets stood at 13.2 % (March -2004) as compared to 12.6 %.in March 2003.The Ministry of Finance’s Economic Survey (2004-05) while reporting the improvements in financial performance and investments of banks, draws attention to the fact that the investments by scheduled commercial banks in Government and other securities stood at 41.5 % of net demand and time liabilities in March 2003 and 41.3 % in March 2004 well above the stipulated SLR ratio of 25%. The slight decline in 2003-04 was on account of higher growth of bank credit to the commercial sector and lower level of market borrowings by the Central Government. The relatively high investments in risk free government securities have led to the criticism that the commercial banks are seeking returns from safer sources, while depriving the productive sector of its much needed credit.

    Details published by the Reserve Bank of India and the Economic Survey serve to underline the fact that the priority sector lending, particularly to agriculture credit has suffered over the years and, the authorities, tried to remedy  the situation .Government of India established Rural Infrastructure Development Fund in 1995-96, with the stipulation that Commercial Banks contribute to the extent of shortfall in priority sector lending to the RIDF maintained by NABARD, which in turn provided funds to State Governments and State Corporate bodies to complete on going rural infrastructure projects. Despite increase in corpus funds, changes in the scope of the project and revision in the rates of interest on contributions, there is continuing concern on priority sector lending and pace of RIDF disbursement. Official sources do admit that even after definitional changes, while the overall target fixed for priority sector lending has been met by all bank groups, there were shortfalls in meeting the subsectoral targets. The decline in the share of  SSI sector in the net bank credit has been a matter of grave concern, marked by a decline from 14.2 to 10.4 % in the case of public sector banks , 13.8 to 7.1% in private sector banks and 10.6 to 10.4 % in the case of foreign banks between 2000-01 to 2003-04 . This led the RBI to constitute a Working group on Flow of credit to SSI sector and the Report of the Group has been available since April 2004. The problems relating to agriculture credit are too well known to need emphasis and the Report of the Advisory Committee on Flow of Credit to agriculture and related activities(June 2004) has made RBI announce a number of measures to improve credit to agriculture. Despite emphasis by the RBI and the Government of India, there are serious questions still remaining to be addressed in provision of credit to productive and priority sectors.


                                                                                                 

     
     

    The need is therefore as much of for deepening and widening the channels of credit flow in the domestic economy as for complying with international standards and regulations.

    The annual credit policy statement for 2005-06 made by Governor, RBI, indicated improvement in credit flow to various sectors of economy in 2004-05 – increase of 23.1% in agriculture, 12.6% in industrial credit 38.6% in credit for infrastructure sector, all higher than the levels of increase in 2003-04. The Governor has pointed out that the impetus to credit growth has emanated from non-agriculture, on-industrial sectors particularly housing small transport operators and retail loans and that while credit flow to these sectors continues to remain buoyant, more raising indications are that credit agriculture and industry has also picked up.

    The investments by banks also need a review. In his address “Emerging Challenges before the Indian Banks – The Road Ahead” Sri. V.Leeladhar, Dy. Governor, RBI has observed “Aided by a good macro economic environment banks’ bottom line has improved significantly over the last three years. However let us not forget that a major contributor to the windfall gains has been treasury profits fuelled by a secular decline in interest rates during the three years from 2001 to 04 and the consequent profit booking on sale of government securities. From the current year with the hardening of interest rates, this trading component of profits is no longer going to shore up banks’ profitability. On the contrary most banks have been required to provide for the decline in the market value of their investment portfolio. Thankfully one off setting factor has been the strong pickup in the credit off take due to buoyant demand in the economy and revival of industrial activity which have resulted in substantial increase in banks’ core interest income.”
    Managing capital adequacy and profitability even while meeting the multi-sectoral demands is an important challenge for the scheduled commercial banks.

    Basel-II
    Reserve Bank of India has drawn up the time schedule for commercial banks to reach global standards and adopt international best practices with country specific adaptations. While the banks have to improve their technological and management skills, the need to rise to the demands of Basel-II norms bring in different set of challenges particularly in the prospect of higher capital allocation on account of operational risks, estimated by some to be in the range of 12 to 15 % of banks gross incomes. It is quite possible that this may build pressures on the banks’ current capital adequacy ratio and oblige the banks to seek the capital market support for funds to comply with Basel-II norms. Whether this will set off an inter-bank competition for the funds and whether all the banks can bear the costs of complying with higher capital requirements needs to be assessed in the light of the rules governing capital weighting for various entities. The expert view is that the new system will be far more complex than what the Indian Banks have so far been accustomed to and the demands for superior information technology and supervisory skills may need to be addressed and met within the time frame envisaged by the Reserve Bank of India to make the system Basel-II compliant.

    We have to note the observation of Mr. Nicholas Le Pan, Chairman of Basel Accord Implementation Group, that “ Base-II is much more than a compliance exercise. Simply enacting new rules and checking periodically to ensure that they are respected is not enough. Basel-II puts onus on Banks’ Boards and management to focus more on the measurement and management of risks and to better relate risks to capital. It is very important that they incorporate this approach into their governance and actively manage their institutions with this risk focus.” (Speech at 6th Annual Global Association of Risk Professionals 1st February 2005)
     

    Proposed Changes in Banking Regulations
    It is clear that the new norms will redefine the course and content of dialogue between banks and the supervisory authority. With a view to help Indian banking system keep pace with the major changes taking place in the international financial firmament, the Government of India have recently proposed some legislative measures to provide scope for greater operational freedom to the key regulator and banking units. While the banking industry has over the last few years geared itself to changes in ownership forms, organisational structures and operational norms, the Government of India decision to amend the Reserve Bank of India Act of 1934 and the Banking Regulations Act of 1949 may accord greater operational flexibility to the Central Bank, and provide it with more powers to monitor and streamline the operations of all domestic banks. As per the existing provisions of the Banking Regulation Act and the Reserve Bank of India Act variation in Statutory Liquidity Ratio can be made upto a minimum of 25 % of Bank deposits and the Cash Reserve Ratio 3 % .  The proposed amendments would enable the Reserve Bank of India to revise the limits on Statutory Liquidity Ratio (SLR) and the Cash Reserve Ratio (CRR) according to its best judgement and release more funds to meet the productive needs of the economy. The proposed amendment will also enable the RBI to regulate the market for interest rate contracts including conventional securities, money market instruments and derivatives and to classify securities issued by the Centre, the states and other entities as “approved securities”. to align the voting rights of investors in keeping with their share holding. This in a way will facilitate the revision of the cap on voting rights of foreign investors now fixed at 10 %. The amendments will also enable the banks to issue preference shares to keep in line with the prudential norms in adherence to the Basel-II accord The RBI will also secure powers to grant exemption to any banking company from Section- 20 of the Banking Regulation Act and extending to it the freedom to grant loans and advances to any company. secure greater monitoring of the powers to examine financial statements or business affairs of associate entities of banks and to supersede the Board of Directors of any bank if deemed necessary. The proposed amendments to the Banking Regulation Act will enable primary credit societies to obtain licenses from the RBI for engaging in the business of banking with corresponding provision providing the RBI the powers to order special audit of the accounts of the primary societies. The Union Government has also proposed to amend the Credit Information (Regulation) Bill 2004 to facilitate the setting up of Credit Information Bureau to collect share and disseminate information on loans taken from banks largely with a view to improve quality of credit appraisal and decision making and also improve the proposed monitory amendments.
    As the proposed changes are now before a Select Committee of the Parliament, this is the opportune time to discuss the implementational  challenges faced by the banks. The Seminar on “Banking Sector Reforms- Looking Ahead” has been convened to share information and expert insights on the trends and recent developments in the sector as also to address issues of preparedness to meet the challenges, rising on the horizon. An attempt has been made in this volume to provide back ground papers to enable participants to reflect on the vital issues that need immediate attention.

                                                                                                                   V.K.Srinivasan
                                                                Vice Chairman and Hon. Director
    Indian Institute of Economics.

     
     

    Banking Sector Reforms in India: An Overview

    DR. Y. V. Reddy

    While presenting  an overview of banking sector reforms in India, it is useful to very briefly recall the nature of the Indian banking sector at the time of initiation of financial sector reforms in India in the early 1990s. The Indian financial system in the pre-reform period (i.e., prior to Gulf crisis of 1991), essentially catered to the needs of planned development in a mixed-economy framework where the public sector had a dominant role in economic activity. The strategy of planned economic development required huge development expenditure, which was met through Government’s dominance of ownership of banks, automatic monetization of fiscal deficit and subjecting the banking sector to large pre-emptions – both in terms of the statutory holding of Government securities (statutory liquidity ratio, or SLR) and cash reserve ratio (CRR). Besides, there was a complex structure of administered interest rates guided by the social concerns, resulting in cross-subsidization. These not only distorted the interest rate mechanism but also adversely affected the viability and profitability of banks by the end of 1980s.  There is perhaps an element of commonality of such a ‘repressed’ regime in the financial sector of many emerging market economies. It follows that the process of reform of financial sector in most emerging economies also has significant commonalities while being specific to the circumstances of each country.  A narration of the broad contours of reform in India would be helpful in appreciating both the commonalities and the differences in our paths of reforms.

    Contours of Banking Reforms in India
    First, reform measures were initiated and sequenced to create an enabling environment for banks to overcome the external constraints – these were related to administered structure of interest rates, high levels of pre-emption in the form of reserve requirements, and credit allocation to certain sectors.  Sequencing of interest rate deregulation has been an important component of the reform process which has imparted greater efficiency to resource allocation. The process has been gradual and predicated upon the institution of prudential regulation for the banking system, market behaviour, financial opening and, above all, the underlying macroeconomic conditions. The interest rates in the banking system have been largely deregulated except for certain specific classes; these are: savings deposit accounts, non-resident Indian (NRI) deposits, small loans up to Rs.2 lakh and export credit.  The need for continuance of these prescriptions as well as those relating to priority sector lending have been flagged for wider debate in the latest annual policy of the RBI. However, administered interest rates still prevail in small savings schemes of the Government.
               
    Second, as regards the policy environment of public ownership, it must be recognised that the lion’s share of financial intermediation was accounted for by the public sector during the pre-reform period. As part of the reforms programme, initially, there was infusion of capital by the Government in public sector banks, which was followed by expanding the capital base with equity participation by the private investors.  The share of the public sector banks in the aggregate assets of the banking sector has come down from 90 per cent in 1991 to around 75 per cent in 2004. The share of wholly Government-owned public sector banks (i.e., where no diversification of ownership has taken place) sharply declined from about 90 per cent to 10 per cent of aggregate assets of all scheduled commercial banks during the same period. Diversification of ownership has led to greater market accountability and improved efficiency. Since the initiation of reforms, infusion of funds by the Government into the public sector banks for the purpose of recapitalisation amounted, on a cumulative basis, to less than one per cent of India’s GDP, a figure much lower than that for many other countries.  Even after accounting for the reduction in the Government's shareholding on account of losses set off, the current market value of the share capital of the Government in public sector banks has increased manifold and as such what was perceived to be a bail-out of public sector banks by Government seems to be turning out to be a profitable investment for the Government. 
                    Third, one of the major objectives of banking sector reforms has been to enhance efficiency and productivity through competition.  Guidelines have been laid down for establishment of new banks in the private sector and the foreign banks have been allowed more liberal entry. Since 1993, twelve new private sector banks have been set up.  As already mentioned, an element of private shareholding in public sector banks has been injected by enabling a reduction in the Government shareholding in public sector banks to 51 per cent. As a major step towards enhancing competition in the banking sector, foreign direct investment in the private sector banks is now allowed up to 74 per cent, subject to conformity with the guidelines issued from time to time. 

    Fourth, consolidation in the banking sector has been another feature of the reform process. This also encompassed the Development Financial Institutions (DFIs), which have been providers of long-term finance while the distinction between short-term and long-term finance provider has increasingly become blurred over time. The complexities involved in harmonising the role and operations of the DFIs were examined and the RBI enabled the reverse-merger of a large DFI with its commercial banking subsidiary which is a major initiative towards universal banking. Recently, another large term-lending institution has been converted into a bank. While guidelines for mergers between non-banking financial companies and banks were issued some time ago, guidelines for mergers between private sector banks have been issued a few days ago.  The principles underlying these guidelines would be applicable, as appropriate, to the public sector banks also, subject to the provisions of the relevant legislation.

    Fifth, impressive institutional and legal reforms have been undertaken in relation to the banking sector.  In 1994, a Board for Financial Supervision (BFS) was constituted comprising select members of the RBI Board with a variety of professional expertise to exercise 'undivided attention to supervision'.  The BFS, which generally meets once a month, provides direction on a continuing basis on regulatory policies including governance issues and supervisory practices.  It also provides direction on supervisory actions in specific cases.  The BFS also ensures an integrated approach to supervision of commercial banks, development finance institutions, non-banking finance companies, urban cooperatives banks and primary dealers. A Board for Regulation and Supervision of Payment and Settlement Systems (BPSS) has also been recently constituted to prescribe policies relating to the regulation and supervision of all types of payment and settlement systems, set standards for existing and future systems, authorise the payment and settlement systems and determine criteria for membership to these systems. The Credit Information Companies (Regulation) Bill, 2004 has been passed by both the Houses of the Parliament while the Government Securities Bills, 2004 is under process. Certain amendments are being considered by the Parliament to enhance Reserve Bank’s regulatory and supervisory powers.  Major amendments relate to requirement of prior approval of RBI for acquisition of five per cent or more of shares of a banking company with a view to ensuring ‘fit and proper’ status of the significant shareholders, aligning the voting rights with the economic holding and empowering the RBI to supersede the Board of a banking company.

    Sixth, there have been a number of measures for enhancing the transparency and disclosures standards. Illustratively, with a view to enhancing further transparency, all cases of penalty imposed by the RBI on the banks as also directions issued on specific matters, including those arising out of inspection, are to be placed in the public domain.

                Seventh, while the regulatory framework and supervisory practices have almost converged with the best practices elsewhere in the world, two points are noteworthy. First, the minimum capital to risk assets ratio (CRAR) has been kept at nine per cent i.e., one percentage point above the international norm; and second, the banks are required to maintain a separate Investment Fluctuation Reserve (IFR) out of profits, towards interest rate risk, at five per cent of their investment portfolio under the categories ‘held for trading’ and ‘available for sale’. This was prescribed at a time when interest rates were falling and banks were realizing large gains out of their treasury activities. Simultaneously, the conservative accounting norms did not allow banks to recognize the unrealized gains. Such unrealized gains coupled with the creation of IFR helped in cushioning the valuation losses required to be booked when interest rates in the longer tenors have moved up in the last one year or so.


    Edited version of an address by Dr. Y.V. Reddy, Governor, Reserve Bank of India at the Institute of Bankers of Pakistan, Karachi on May 18, 2005.

    Eighth, of late, the regulatory framework in India, in addition to prescribing prudential guidelines and encouraging market discipline, is increasingly focusing on ensuring good governance through "fit and proper" owners, directors and senior managers of the banks. Transfer of shareholding of five per cent and above requires acknowledgement from the RBI and such significant shareholders are put through a `fit and proper' test. Banks have also been asked to ensure that the nominated and elected directors are screened by a nomination committee to satisfy `fit and proper' criteria. Directors are also required to sign a covenant indicating their roles and responsibilities. The RBI has recently issued detailed guidelines on ownership and governance in private sector banks emphasizing diversified ownership. The listed banks are also required to comply with governance principles laid down by the SEBI – the securities markets regulator.

    Processes of Banking Reform

                The processes adopted for bringing about the reforms in India may be of some interest to this audience.  Recalling some features of financial sector reforms in India would be in order, before narrating the processes.   First, financial sector reform was undertaken early in the reform-cycle in India.  Second, the financial sector was not driven by any crisis and the reforms have not been an outcome of multilateral aid.  Third, the design and detail of the reform were evolved by domestic expertise, though international experience is always kept in view.   Fourth, the Government preferred that public sector banks manage the over-hang problems of the past rather than cleanup the balance sheets with support of the Government.  Fifth, it was felt that there is enough room for growth and healthy competition for public and private sector banks as well as foreign and domestic banks.  The twin governing principles are non-disruptive progress and consultative process.
    In order to ensure timely and effective implementation of the measures, RBI has been adopting a consultative approach before introducing policy measures.  Suitable mechanisms have been instituted to deliberate upon various issues so that the benefits of financial efficiency and stability percolate to the common person and the services of the Indian financial system can be benchmarked against international best standards in a transparent manner.  Let me give a brief account of these mechanisms.

    First, on all important issues, workings group are constituted or technical reports are prepared, generally encompassing a review of the international best practices, options available and way forward.  The group membership may be internal or external to the RBI or mixed.  Draft reports are often placed in public domain and final reports take account of inputs, in particular from industry associations and self-regulatory organizations. The reform-measures emanate out of such a series of reports, the pioneering ones being: Report of the Committee on the Financial System (Chairman: Shri M. Narasimham), in 1991; Report of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan) in 1992; and the Report of the Committee on Banking Sector Reforms (Chairman: Shri M. Narasimham) in 1998.

    Second, Resource Management Discussions meetings are held by the RBI with select commercial banks, prior to the policy announcements.  These meetings not only focus on perception and outlook of the bankers on the economy, liquidity conditions, credit flow, development of different markets and directions of interest rates, but also on issues relating to developmental aspects of banking operations.

    Third, we have formed a Technical Advisory Committee on Money, Foreign Exchange and Government Securities Markets (TAC). It has emerged as a key consultative mechanism amongst the regulators and various market players including banks.  The Committee has been crystallizing the synergies of experts across various fields of the financial market and thereby acting as a facilitator for the RBI in steering reforms in money, government   securities and foreign exchange markets.

    Fourth, in order to strengthen the consultative process in the regulatory domain and to place such a process on a continuing basis, the RBI has constituted a Standing Technical Advisory Committee on Financial Regulation on the lines similar to the TAC. The Committee consists of experts drawn from academia, financial markets, banks, non-bank financial institutions and credit rating agencies. The Committee examines the issues referred to it and advises the RBI on desirable regulatory framework on an on-going basis for banks, non-bank financial institutions and other market participants.

    Fifth, for ensuring periodic formal interaction, amongst the regulators, there is a High Level Co-ordination Committee on Financial and Capital Markets (HLCCFCM) with the Governor, RBI as the Chairman, and the Heads of the securities market and insurance regulators, and the Secretary of the Finance Ministry as the members. This Co-ordination Committee has authorised constitution of several standing committees to ensure co-ordination in regulatory frameworks at an operational level.

    Sixth, more recently a Standing Advisory Committee on Urban Co-operative Banks (UCBs) has been activated to advise on structural, regulatory and supervisory issues relating to UCBs and to facilitate the process of formulating future approaches for this sector.  Similar mechanisms are being worked out for non-banking financial companies.

    Seventh, the RBI has also instituted a mechanism of placing draft versions of important guidelines for comments of the public at large before finalisation of the guidelines. To further this consultative process and with a specific goal of making the regulatory guidelines more user-friendly, a Users’ Consultative Panel has been constituted comprising the representatives of select banks and market participants. The panel provides feedback on regulatory instructions at the formulation stage to avoid any subsequent ambiguities and operational glitches.

    Eighth, an extensive and transparent communication system has been evolved.  The annual policy statements and their mid-term reviews communicate the RBI’s stance on monetary policy in the immediate future of six months to one year. Over the years, the reports of various working groups and committees have emerged as another plank of two-way communication from RBI.  An important feature of the RBI’s communication policy is the almost real-time dissemination of information through its web-site. The auction results under Liquidity Adjustment Facility (LAF) of the day are posted on the web-site by 12.30 p.m the same day, while by 2.30 p.m. the ‘reference rates’ of select foreign currencies are also placed on the website.  By the next day morning, the press release on money market operations is issued. Every Saturday, by 12 noon, the weekly statistical supplement is placed on the web-site providing a fairly detailed, recent data-base on the RBI and the financial sector. All the regulatory and administrative circulars of different Departments of the RBI are placed on the web-site within half an hour of their finalization.

    Ninth, an important feature of the reform of the Indian financial system has been the intent of the authorities to align the regulatory framework with international best practices keeping in view the developmental needs of the country and domestic factors. Towards this end, a Standing Committee on International Financial Standards and Codes was constituted in 1999. The Standing Committee had set up ten Advisory Groups in key areas of the financial sector whose reports are available on the RBI website. The recommendations contained in these reports have either been implemented or are in the process of implementation. I would like to draw your attention to two reports in particular, which have a direct bearing on the banking system, viz., Advisory Group on Banking Supervision and Advisory Group on Corporate Governance.  Subsequently, in 2004, we conducted a review of the recommendations of the Advisory Groups and reported the progress and agenda ahead.

    What has been the Impact?

    These reform measures have had major impact on the overall efficiency and stability of the banking system in India. The present capital adequacy of Indian banks is comparable to those at international level. There has been a marked improvement in the asset quality with the percentage of gross non-performing assets (NPAs) to gross advances for the banking system reduced from 14.4 per cent in 1998 to 7.2 per cent in 2004. The reform measures have also resulted in an improvement in the profitability of banks.  The Return on Assets (RoA) of the banks rose from 0.4 per cent in the year 1991-92 to 1.2 per cent in 2003-04. Considering that, globally, the RoA has been in the range 0.9 to 1.5 per cent for 2004, Indian banks are well placed. The banking sector reforms also emphasized the need to review the manpower resources and rationalize the requirements by drawing a realistic plan so as to reduce the operating cost and improve the profitability. During the last five years, the business per employee for public sector banks more than doubled to around Rs.25 million in 2004. 

    Continuity, Change and Context

                We lay considerable emphasis on appropriate mix between the elements of continuity and change in the process of reform, but the dynamic elements in the mix are determined by the context.  While there is usually a consensus on the broad direction, relative emphasis on various elements of the process of reform keeps changing, depending on the evolving circumstances.  Perhaps it will be useful to illustrate this approach to contextualising the mix of continuity and change.

                The mid-term review in November 2003, reviewed the progress of implementation of various developmental as well as regulatory measures in the banking sector but emphasised facilitating the ease of transactions by the common person and strengthening the credit delivery systems, as a response to the pressing needs of the society and economy.  The annual policy statement of May 2004 carried forward this focus but flagged major areas requiring urgent attention especially in the areas of ownership, governance, conflicts of interest and customer-protection.  Some extracts of the policy statement may be in order:

    "First, it is necessary to articulate in a comprehensive and transparent manner the policy in regard to ownership and governance of both public and private sector banks keeping in view the special nature of banks.  This will also facilitate the ongoing shift from external regulation to internal systems of controls and risk assessments.  Second, from a systemic point .

     
     

    of view, inter-relationships between activities of financial intermediaries and areas of conflict of interests need to be considered.  Third, in order to protect the integrity of the financial system by reducing the likelihood of their becoming conduits for money laundering, terrorist financing and other unlawful activities and also to ensure audit trail, greater accent needs to be laid on the adoption of an effective consolidated know your customer (KYC) system, on both assets and liabilities, in all financial intermediaries regulated by RBI.  At the same time, it is essential that banks do not seek intrusive details from their customers and do not resort to sharing of information regarding the customer except with the written consent of the customer.  Fourth, while the stability and efficiency imparted to the large commercial banking system is universally recognised, there are some segments which warrant restructuring."   
                The annual policy statement for the current year reiterates the concern for common person, while enunciating a medium term framework, for development of money, forex and government securities markets;  for enhancing credit flow to agriculture and small industry; for action points in technology and payments systems; for institutional reform in co-operative banking, non-banking financial companies and regional rural banks; and, for ensuring availability of quality services to all sections of the population.  The most distinguishing feature of the policy statement relates to the availability of banking services to the common person, especially depositors. 
                The statement reiterates that depositors’ interests form the focal point of the regulatory framework for banking in India, and elaborates the theme as follows:
    “A licence to do banking business provides the entity, the ability to accept deposits and access to deposit insurance for small depositors.  Similarly, regulation and supervision by RBI enables these entities to access funds from a wider investor base and the payment and settlement systems provides efficient payments and funds transfer services.  All these services, which are in the nature of public good, involve significant costs and are being made available only to ensure availability of banking and payment services to the entire population without discrimination”.
                The policy draws attention to the divergence in treatment of depositors compared to borrowers as:
    “ … while policies relating to credit allocation, credit pricing and credit restructuring should continue to receive attention, it is inappropriate to ignore the mandate relating to depositors’ interests.  Further, in our country, the socio-economic profile for a typical depositor who seeks safe avenues for his savings deserves special attention relative to other stakeholders in the banks”.

                Another significant area of concern has been the possible exclusion of a large section of population from the provision of services and the Statement pleads for financial inclusion.  It states:
    “There has been expansion, greater competition and diversification of ownership of banks leading to both enhanced efficiency and systemic resilience in the banking sector.  However, there are legitimate concerns in regard to the banking practices that tend to exclude rather than attract vast sections of population, in particular pensioners, self-employed and those employed in unorganised sector.  While commercial considerations are no doubt important, the banks have been bestowed with several privileges, especially of seeking public deposits on a highly leveraged basis, and consequently they should be obliged to provide banking services to all segments of the population, on equitable basis.”   

    Operationally, it has been made clear that RBI will implement policies to encourage banks which provide extensive services while disincentivising those which are not responsive to the banking needs of the community, including the underprivileged.
                The quality of services rendered has also invited attention in the current policy. I quote further,
    “Liberalisation and enhanced competition accord immense benefits, but experience has shown that consumers’ interests are not necessarily accorded full protection and their grievances are not properly attended to.  Several representations are being received in regard to recent trends of levying unreasonably high service/user charges and enhancement of user charges without proper and prior intimation. Taking account of all these considerations, it has been decided by RBI  to set up an independent Banking Codes and Standards Board of India on the model of the mechanism in the UK in order to ensure that comprehensive code of conduct for fair treatment of customers are evolved and adhered to”.
                It is essential to recognise that, while these constitute contextual nuanced responses to changing circumstances within the country, the overwhelming compulsion to be in harmony with global developments must be respected and that essentially relates to Basel II.
    Basel II and India
    RBI’s association with the Basel Committee on Banking Supervision dates back to 1997 as India was among the 16 non-member countries that were consulted in the drafting of the Basel Core Principles. Reserve Bank of India became a member of the Core Principles Liaison Group in 1998 and subsequently became a member of the Core Principles Working Group on Capital. Within the Working Group, RBI has been actively participating in the deliberations on the New Accord and had the privilege to lead a group of six major non-G-10 supervisors which presented a proposal on a simplified approach for Basel II to the Committee.
    Commercial banks in India will start implementing Basel II with effect from March 31, 2007. They will adopt Standardised Approach for credit risk and Basic Indicator Approach for operational risk, initially. After adequate skills are developed, both at the banks and also at supervisory levels, some banks may be allowed to migrate to the Internal Rating Based (IRB) Approach.
    Let me briefly review the steps taken for implementation of Basel II and the emerging issues. The RBI had announced in its annual policy statement in May 2004 that banks in India should examine in depth the options available under Basel II and draw a road-map by end-December 2004 for migration to Basel II and review the progress made at quarterly intervals. The Reserve Bank organized a two-day seminar in July 2004 mainly to sensitise the Chief Executive Officers of banks to the opportunities and challenges emerging from the Basel II norms. Soon thereafter all banks were advised in August 2004 to undertake a self-assessment of the various risk management systems in place, with specific reference to the three major risks covered under the Basel II and initiate necessary remedial measures to update the systems to match up to the minimum standards prescribed under the New Framework. Banks have also been advised to formulate and operationalise the Capital Adequacy Assessment Process (CAAP) within the banks as required under Pillar II of the New Framework.
    It is appropriate to list some of the other regulatory initiatives taken by the Reserve Bank of India, relevant for Basel II. First, we have tried to ensure that the banks have suitable risk management framework oriented towards their requirements dictated by the size and complexity of business, risk philosophy, market perceptions and the expected level of capital. Second, Risk Based Supervision (RBS) in 23 banks has been introduced on a pilot basis. Third, we have been encouraging banks to formalize their capital adequacy assessment process (CAAP) in alignment with their business plan and performance budgeting system.  This, together with the adoption of RBS would aid in factoring the Pillar II requirements under Basel II.   Fourth, we have been expanding the area of disclosures (Pillar III), so as to have greater transparency in the financial position and risk profile of banks.  Finally, we have tried to build capacity for ensuring the regulator’s ability for identifying and permitting eligible banks to adopt IRB / Advanced Measurement approaches.
    As per normal practice, and with a view to ensuring migration to Basel II in a non-disruptive manner, a consultative and participative approach has been adopted for both designing and implementing Basel II. A Steering Committee comprising senior officials from 14 banks (public, private and foreign) has been constituted wherein representation from the Indian Banks’ Association and the RBI has also been ensured. The Steering Committee had formed sub-groups to address specific issues. On the basis of recommendations of the Steering Committee, draft guidelines to the banks on implementation of the New Capital Adequacy Framework have been issued.
                Implementation of Basel II will require more capital for banks in India due to the fact that operational risk is not captured under Basel I, and the capital charge for market risk was not prescribed until recently. Though last year has not been a very good year for banks, they are exploring all avenues for meeting the capital requirements under Basel II. The cushion available in the system, which has a CRAR of over 12 per cent now, is, however, comforting.

    India has four rating agencies of which three are owned partly/wholly by international rating agencies. Compared to developing countries, the extent of rating penetration has been increasing every year and a large number of capital issues of companies has been rated.  However, since rating is of issues and not of issuers, it is likely to result, in effect, in application of only Basel I standards for credit risks in respect of non-retail exposures. While Basel II provides some scope to extend the rating of issues to issuers, this would only be an approximation and it would be necessary for the system to move to rating of issuers. Encouraging rating of issuers would be essential in this regard.  In this context, current non-availability of acceptable and qualitative historical data relevant to ratings, along with the related costs involved in building up and maintaining the requisite database, does influence the pace of migration to the advanced approaches available under Basel  II.
    Above all, capacity building, both in banks and the regulatory bodies is a serious challenge, especially with regard to adoption of the advanced approaches. We in India have initiated supervisory capacity-building measures to identify the gaps and to assess as well as quantify the extent of additional capital which may be required to be maintained by such banks. The magnitude of this task, which is scheduled to be completed by December 2006, appears daunting since we have as many as 90 scheduled commercial banks in India.

    Concluding Observations
    In the current scenario, banks are constantly pushing the frontiers of risk management. Compulsions arising out of increasing competition, as well as agency problems between management, owners and other stakeholders are inducing banks to look at newer avenues to augment revenues, while trimming costs. Consolidation, competition and risk management are no doubt critical to the future of banking but I believe that governance and financial inclusion would also emerge as the key issues for a country like India, at this stage of socio-economic development.

     
     

    Financial Sector Reforms in India: Policies and Performance Analysis*
    Rakesh  Mohan

    I. INTRODUCTION
    As the economy grows and becomes more sophisticated, the banking sector has to develop pari pasu in a manner that it supports and stimulates such growth. With increasing global integration, the Indian banking system and financial system has as a whole had to be strengthened so as to be able to compete. India has had more than a decade of financial sector reforms during which there has been substantial transformation and liberalisation of the whole financial system. It is, therefore, an appropriate time to take stock and assess the efficacy of our approach. It is useful to evaluate how the financial system has performed in an objective quantitative manner. This is important because India’s path of reforms has been different from most other emerging market economies: it has been a measured, gradual, cautious, and steady process, devoid of many flourishes that could be observed in other countries.
    Until the beginning of the 1990s, the state of the financial sector in India could be described as a classic example of “financial repression” a la MacKinnon and Shaw. The sector was characterised, inter alia,by administered interest rates, large pre-emption of resources by the authorities and extensive micro-regulations directing the major portion of the flow of funds to and from financial intermediaries. While the true health of financial intermediaries, most of them public sector entities, was masked by relatively opaque accounting norms and limited disclosure, there were general concerns about their viability. Insurance companies – both life and non-life - were all publicly owned and offered very little product choice. In the securities market, new equity issues were governed by a plethora of complex regulations and extensive restrictions. There was very little transparency and depth in the secondary market trading of such securities. Interest rates on government securities, the predominant segment of fixed-income securities, were decided through administered fiat. The market for such securities was a captive one where the players were mainly financial intermediaries, who had to invest in government securities to fulfill high statutory reserve requirements. There was little depth in the foreign exchange market as most such transactions were governed by inflexible and low limits and also prior approval requirements.

    Compartmentalisation of activities of different types of financial intermediaries eliminated the scope for competition among existing financial intermediaries. In addition, strong entry barriers thwarted competition from new entrants. The end result was low levels of competition, efficiency and productivity in the financial sector, on the one hand, and severe credit constraints for the productive entities, on the other, especially for those in the private sector. The other major drawback of this regime was the scant attention that was placed on the financial health of the intermediaries. Their capitalisation levels were low. The lack of commercial considerations in credit planning and weak recovery culture resulted in large accumulation of non-performing loans. This had no impact on the confidence of depositors, however, because of government ownership of banks and financial intermediaries.

    The predominance of Government securities in the fixed-income securities market of India mainly reflects the captive nature of this market as most financial intermediaries need to invest a sizeable portion of funds mobilised by them in such securities. While such norms were originally devised as a prudential measure, during certain periods, such statutory norms pre-empted increasing proportions of financial resources from intermediaries to finance high Government borrowings.

    The interest rate on Government debt was administered and the rate of interest charged by the Reserve Bank of India (RBI) for financing Government deficit was concessional. On top of this, there were limited external capital flows. Such a closed-economy set-up kept debt markets underdeveloped and devoid of any competitive forces. In addition, there was hardly any secondary market for Government securities, and such transactions were highly opaque and operated through over-the-telephone deals. The provision of fiscal accommodation through ad hoc treasury bills led to high levels of monetisation of fiscal deficit during the major part of the 1980s.

    The phase of nationalisation and ‘social control’ of financial intermediaries, however, was not without considerable positive implications as well. The sharp increase in rural branches of banks increased deposit and savings growth considerably. There was a marked rise in credit flow towards economically important but hitherto neglected activities, most notably agriculture and small-scale industries. The urban-bias and marked preference of banks to lend to the industrial sector, especially large industrial houses, was contained. The implicit guarantee emanating from public ownership created an impression of infallibility of these institutions and the expectation was self-fulfilling – there was no major episode of failure of financial intermediaries in this period.

    Starting from such a position, it is widely recognised that the Indian financial sector over the last decade has been transformed into a reasonably sophisticated, diverse and resilient system. However, this transformation has been the culmination of extensive, well-sequenced and coordinated policy measures aimed at making the Indian financial sector efficient, competitive and stable.
    The main objectives, therefore, of the financial sector reform process in India initiated in the early 1990s have been to :

    • Remove financial repression that existed earlier;
    • Create an efficient, productive and profitable financial sector industry;
    • Enable price discovery, particularly, by the market determination of interest rates that then helps in efficient allocation    of resources;
    • Provide operational and functional autonomy to institutions;
    • Prepare the financial system for increasing international competition;
    • Open the external sector in a calibrated fashion;
    • Promote the maintenance of financial stability even in the face of domestic and external shocks.

     

    Since there is a rich array of literature analysing the anthology of the reform process per se, the story of policy reforms in the India financial sector since the early 1990s is quite well known.1 What is less probed, however, is the outcome. In fact, from the vantage point of 2004, one of the successes of the Indian financial sector reform has been the maintenance of financial stability and avoidance of any major financial crisis during the reform period - a period that has been turbulent for the financial sector in most emerging market countries. The domain of analysis of the paper is, however, somewhat limited. Specifically, this paper limits itself to the impact analysis of financial sector reforms in the areas where the Reserve Bank of India has had a dominant role. These include the banking sector, foreign exchange and government securities markets and also the conduct of monetary policy.
    The rest of the paper is organised as follows. Section II provides the rationale of financial sector reforms in India. While policy reforms in the financial sector are dealt with in section III, section IV is devoted to reforms in the monetary policy framework. Against this brief chronicle of the financial sector reforms process, I shall look into the outcomes of the financial sector reform process in section V in some detail. Instead of presenting any concluding observations, I shall raise some issues in the last section.

    II. FINANCIAL SECTOR REFORMS: THE APPROACH
    The initiation of financial reforms in the country during the early 1990s was to a large extent conditioned by the analysis and recommendations of various Committees/Working Groups set-up to address specific issues. The process has been marked by ‘gradualism’ with measures being undertaken after extensive consultations with experts and market participants. From the beginning of financial reforms, India has resolved to attain standards of international best practices but to fine tune the process keeping in view the underlying institutional and operational considerations (Reddy, 2002 a). Reform measures introduced across sectors as well as within each sector were planned in such a way so as to reinforce each other. Attempts were made to simultaneously strengthen the institutional framework while enhancing the scope for commercial decision making and market forces in an increasingly competitive framework. At the same time, the process did not lose sight of the social responsibilities of the financial sector. However, for fulfilling such objectives, rather than using administrative fiat or coercion, attempts were made to provide operational flexibility and incentives so that the desired ends are attended through broad interplay of market forces.
    The major aim of the reforms in the early phase of reforms, known as first generation of reforms, was to create an efficient, productive and profitable financial service industry operating within the environment of operating flexibility and functional autonomy. While these reforms were being implemented, the world economy also witnessed significant changes, ‘coinciding with the movement towards global integration of financial services’ [Government of India (GoI), 1998]. The focus of the second phase of financial sector reforms starting from the second-half of the 1990s, therefore, has been the strengthening of the financial system and introduction of structural improvements.
    Two brief points need to be mentioned here. First, financial reforms in the early 1990s were preceded by measures aimed at lessening the extent of financial repression. However, unlike in the latter period, the earlier efforts were not part of a well-thought out and comprehensive agenda for extensive reforms. Second, financial sector reform in India was an important component of the comprehensive economic reform process initiated in the early 1990s. Whereas economic reforms in India were also initiated following an external sector crisis, unlike many other emerging market economies where economic reforms were driven by crisis followed by a boom-bust pattern of policy liberalisation, in India, reforms followed a consensus driven pattern of sequenced liberalisation across the sectors (Ahluwalia, 2002). That is why despite several changes in government there has not been any reversal of direction in the financial sector reform process over the last 15 years.
    As pointed out by Dr.Y.V.Reddy (Reddy, 2002 a), the approach towards financial sector reforms in India is based on panchasutra or five principles:
    1.   Cautious and appropriate sequencing of reform measures.
    2.   Introduction of norms that are mutually reinforcing.
    3.   Introduction of complementary reforms across sectors (most importantly, monetary, fiscal and external sector).
    4.   Development of financial institutions.
    5.   Development of financial markets.
    An important salient feature of the move towards globalisation of the Indian financial system has been the intent of the authorities to more towards international best practices. This is illustrated by the appointment of several advisory groups designed to benchmark Indian practices with international standards in several crucial areas of importance like monetary policy, banking supervision, data dissemination, corporate governance and the like. Towards this end, a Standing Committee on International Financial Standards and Codes (Chairman: Dr. Y. V. Reddy) was constituted and the recommendations contained therein have either been implemented or are in the process of implementation.Having delineated the broad philosophy, let me now turn to specifics of reform. I will paint the story of Indian reform with a broad brush so as to provide a context of the impact analysis that follows.

    III. POLICY REFORMS IN THE FINANCIAL SECTOR
    BANKING REFORMS

    Commercial banking constitutes the largest segment of the Indian financial system. Despite the general approach of the financial sector reform process to establish regulatory convergence among institutions involved in broadly similar activities, given the large systemic implications of the commercial banks, many of the regulatory and supervisory norms were initiated first for commercial banks and were later extended to other types of financial intermediaries.
    After the nationalisation of major banks in two waves, starting in 1969, the Indian banking system became predominantly government owned by the early 1990s. Banking sector reform essentially consisted of a two pronged approach. While nudging the Indian banking system to better health through the introduction of international best practices in prudential regulation and supervision early in the reform cycle, the idea was to increase competition in the system gradually. The implementation periods for such norms were, however, chosen to suit the Indian situation. Special emphasis was placed on building up the risk management capabilities of the Indian banks. Measures were also initiated to ensure flexibility, operational autonomy and competition in the banking sector. Active steps have been taken to improve the institutional arrangements including the legal framework and technological system within which the financial institutions and markets operate. Keeping in view the crucial role of effective supervision in the creation of an efficient and stable banking system, the supervisory system has been revamped. Stylised features of the banking sector reforms have been given in Box I.
    Unlike in other emerging market countries, many of which had the presence of government owned banks and financial institutions, banking reform has not involved large scale privatisation of such banks. The approach, instead, first involved recapitalisation of banks from government resources to bring them up to appropriate capitalisation standards. In the second phase, instead of privatisation, increase in capitalisation has been done through diversification of ownership to private investors up to a limit of 49 per cent, thereby keeping majority ownership and control with the government. With such widening of ownership most of these banks have been publicly listed; this was designed to introduce greater market discipline in bank management, and greater transparency through enhanced disclosure norms. The phased introduction of new private sector banks, and expansion in the number of foreign bank branches, provided for new competition. Meanwhile, increasingly tight capital adequacy, prudential and supervision norms were applied equally to all banks, regardless of ownership.

    DEBT MARKET REFORMS
    Major reforms have been carried out in the government securities (G-Sec) debt market. In fact, it is probably correct to say that a functioning G-Sec debt market was really initiated in the 1990s. The system had to essentially move from a strategy of pre-emption of resources from banks at administered interest rates and through monetisation to a more market oriented system. Prescription of a “statutory liquidity ratio” (SLR), i.e., the ratio at which banks are required to invest in approved securities, though originally devised as a prudential measure, was used as the main instrument of pre-emption of bank resources in the pre-reform period. The high SLR requirement created a captive market for government securities, which were issued at low administered interest rates. After the initiation of reforms, this ratio has been reduced in phases to the statutory minimum level of 25 per cent. Over the past few years numerous steps have been taken to broaden and deepen the Government securities market and to raise the levels of transparency. Automatic monetisation of the Government’s deficit has been phased out and the market borrowings of the Central Government are presently undertaken through a system of auctions at market-related rates. Major facets of the reforms in the government securities are provided in Box II.
    The key lesson learned through this debt market reform process is that setting up such a market is not easy and needs a great deal of proactive work by the relevant authorities. An appropriate institutional framework has to be created for such a market to be built and operated in a sustained manner. Legislative provisions, technology development, market infrastructure such as settlement systems, trading systems, and the like have all to be developed.

    FOREIGN EXCHANGE MARKET REFORMS
    The Indian forex exchange market had been heavily controlled since the 1950s, along with increasing trade controls designed to foster import substitution. Consequently, both the current and capital accounts were closed and foreign exchange was made available by the Reserve Bank of India through a complex licensing system. The task facing India in the early 1990s was therefore to gradually move from total control to a functioning foreign exchange market. The move towards a market-based exchange rate regime in 1993 and the subsequent adoption of current account convertibility were the key measures in reforming the Indian foreign exchange market. Reforms in the foreign exchange market focused on market development with prudential safeguards without destabilising the market (Reddy, 2002 a). Authorised Dealers of foreign exchange have been allowed to carry on a large range of activities. Banks have been given large autonomy to undertake foreign exchange operations. In order to deepen the foreign exchange market, a large number of products have been introduced and entry of newer players has been allowed in the market. Highlights of reforms in the foreign exchange market have been given in Box III.


     
     

    The Indian approach to opening the external sector and developing the foreign exchange market in a phased manner from current account convertibility to the ongoing process of capital account opening is perhaps the most striking success relative to other emerging market economies. There have been no accidents in this process, the exchange rate has been market determined and flexible and the process has been carefully calibrated. The capital account is effectively convertible for non-residents, but has some way to go for residents. The Indian approach has perhaps gained greater international respectability after the enthusiasm for rapid capital account opening has been dimmed since the Asian crisis.

    REFORMS IN OTHER SEGMENTS OF THE FINANCIAL SECTOR
    Measures aimed at establishing prudential regulation and supervision and also competition and efficiency enhancing measures have also been introduced for non-bank financial intermediaries as well. Towards this end, non-banking financial companies (NBFCs), especially those involved in public deposit taking activities, have been brought under the regulation of RBI. Development Finance Institutions (DFIs), specialised term-lending institutions, NBFCs, Urban Cooperative Banks and Primary Dealers have all been brought under the supervision of the Board for Financial Supervision (BFS). With the aim of regulatory convergence for entities involved in similar activities, prudential regulation and supervision norms were also introduced in phases for DFIs, NBFCs and cooperative banks.

    The insurance business remained within the confines of public ownership until the late 1990s. Subsequent to the passage of the Insurance Regulation and Development Act in 1999, several changes were initiated, including allowing newer players/joint ventures to undertake insurance business on risk-sharing/commission basis. The Insurance Regulatory and Development Agency (IRDA) has been established to regulate and supervise the insurance sector.

    With the objective of improving market efficiency, increasing transparency, integration of national markets and prevention of unfair practices regarding trading, a package of reforms comprising measures to liberalise, regulate and develop capital market was introduced. An important step has been the establishment of the Securities and Exchange Board of India (SEBI) as the regulator for equity markets. Since 1992, reform measures in the equity market have focused mainly on regulatory effectiveness, enhancing competitive conditions, reducing information asymmetries, developing modern technological infrastructure, mitigating transaction costs and controlling of speculation in the securities market. Another important development under the reform process has been the opening up of mutual funds to the private sector in 1992, which ended the monopoly of Unit Trust of India (UTI), a public sector entity. These steps have been buttressed by measures to promote market integrity.

    The Indian capital market was opened up for foreign institutional investors (FIIs) in 1992. The Indian corporate sector has been allowed to tap international capital markets through American Depository Receipts (ADRs), Global Depository Receipts (GDRs), Foreign Currency Convertible Bonds (FCCBs) and External Commercial Borrowings (ECBs). Similarly, Overseas Corporate Bodies (OCBs) and non-resident Indians (NRIs) have been allowed to invest in Indian companies. FIIs have been permitted in all types of securities including Government securities and they enjoy full capital convertibility. Mutual funds have been allowed to open offshore funds to invest in equities abroad.

    IV. REFORM IN THE MONETARY POLICY FRAMEWORK
    What has been the change in monetary policy in the wake of these changes in different market segments as well as sectors? The transition of economic policies in general, and financial sector policies in particular, from a control oriented regime to a liberalised but regulated regime has also been reflected in changes in the nature of monetary management. While the basic objectives of monetary policy, namely price stability and ensuring adequate credit flow to support growth, have remained unchanged, the underlying operating environment for monetary policy has undergone a significant transformation. An increasing concern is the maintenance of financial stability. The basic emphasis of monetary policy since the initiation of reforms has been to reduce market segmentation in the financial sector through increase in the linkage between various segments of the financial market including money, government securities and forex market. Major features of the reforms in the monetary policy framework have been provided in Box IV.
    The key policy development that has enabled a more independent monetary policy environment was the discontinuation of automatic monetisation of the government’s fiscal deficit through an agreement between the Government and the Reserve Bank of India in 1997. The enactment of the Fiscal Responsibility and Budget Management Act has strengthened this further : from 2006, the Reserve Bank will no longer be permitted to subscribe to government securities in the primary market. The development of the monetary policy framework has also involved a great deal of institutional initiatives to enable efficient functioning of the money market: development of appropriate trading, payments and settlement systems along with technological infrastructure.
    Box I: Reforms in the Banking Sector

    • Prudential Measures     
      • Introduction and phased implementation of international best practices  and norms on risk-weighted capital adequacy requirement, accounting, income recognition, provisioning and exposure.
    • Measures to strengthen risk management through recognition of different components of risk, assignment of risk-weights to various asset classes, norms on connected lending, risk concentration, application of marked-to-market principle for investment portfolio and limits on deployment of fund in sensitive activities.

    B. Competition Enhancing Measures

    • Granting of operational autonomy to public sector banks, reduction of public ownership in public sector banks by allowing them to raise capital from equity market up to 49 per cent of paid-up capital.
    • Transparent norms for entry of Indian private sector, foreign and joint-venture banks and insurance companies, permission for foreign investment in the financial sector in the form of Foreign Direct Investment (FDI) as well as portfolio investment, permission to banks to diversify product portfolio and business activities.

    C. Measures Enhancing Role of Market Forces

    • Sharp reduction in pre-emption through reserve requirement, market determined pricing for government securities, disbanding of administered interest rates with a few exceptions and enhanced transparency and disclosure norms to facilitate market discipline.
    • Introduction of pure inter-bank call money market, auction-based repos-reverse repos for short-term liquidity management, facilitation of improved payments and settlement mechanism.

    D. Institutional and Legal Measures

    • Settling up of Lok Adalats (people’s courts), debt recovery tribunals, asset reconstruction companies, settlement advisory committees, corporate debt restructuring mechanism, etc. for quicker recovery/ restructuring. Promulgation of Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI), Act and its subsequent amendment to ensure creditor rights.
    • Setting up of Credit Information Bureau for information sharing on defaulters as also other borrowers.
    • Setting up of Clearing Corporation of India Limited (CCIL) to act as central counter party for facilitating payments and settlement system relating to fixed income securities and money market instruments.

    E. Supervisory Measures

    • Establishment of the Board for Financial Supervision as the apex supervisory authority for commercial banks, financial institutions and non-banking financial companies.
    • Introduction of CAMELS supervisory rating system, move towards risk-based supervision, consolidated supervision of financial conglomerates, strengthening of off-site surveillance through control returns.
    • Recasting of the role of statutory auditors, increased internal control through strengthening of internal audit.
    • Strengthening corporate governance, enhanced due diligence on important shareholders, fit and proper tests for directors.

     

    Technology Related Measures

    • Setting up of INFINET as the communication backbone for the financial sector, introduction of Negotiated Dealing System (NDS) for screen-based trading in government securities and Real Time Gross Settlement (RTGS) System.

    Box II: Reforms in the Government Securities Market

    Institutional Measures

    • Administered interest rates on government securities were replaced by an auction system for price discovery.
    • Automatic monetisation of fiscal deficit through the issue of ad hoc Treasury Bills was phased out.
    • Primary Dealers (PD) were introduced as market makers in the government securities market.
    • For ensuring transparency in the trading of government securities, Delivery versus Payment (DvP) settlement system was introduced.
    • Repurchase agreement (repo) was introduced as a tool of short-term liquidity adjustment. Subsequently, the Liquidity Adjustment Facility (LAF) was introduced. LAF operates through repo and reverse repo auctions to set up a corridor for short-term interest rate. LAF has emerged as the tool for both liquidity management and also signalling device for interest rates in the overnight market.
    • Market Stabilisation Scheme (MSS) has been introduced, which has expanded the instruments available to the Reserve Bank for managing the surplus liquidity in the system.

    Increase in Instruments in the Government Securities Market

    • 91-day Treasury bill was introduced for managing liquidity and benchmarking. Zero Coupon Bonds, Floating Rate Bonds, Capital Indexed Bonds were issued and exchange traded interest rate futures were introduced. OTC interest rate derivatives like IRS/ FRAs were introduced.

    Enabling Measures

    • Foreign Institutional Investors (FIIs) were allowed to invest in government securities subject to certain limits.
    • Introduction of automated screen-based trading in government securities through Negotiated Dealing System (NDS). Setting up of risk-free payments and settlement system in government securities through Clearing Corporation of India Limited (CCIL). Phased introduction of Real Time Gross Settlement System (RTGS). Introduction of trading of government securities on stock exchanges for promoting retailing in such securities, permitting non-banks to participate in repo market.

    Box III: Reforms in the Foreign Exchange Market

    Exchange Rate Regime

    • Evolution of exchange rate regime from a single-currency fixed-exchange rate system to fixing the value of rupee against a basket of currencies and further to market-determined floating exchange rate regime.
    • Adoption of convertibility of rupee for current account transactions with acceptance of Article VIII of the Articles of Agreement of the IMF. De facto full capital account convertibility for non residents and calibrated liberalisation of transactions undertaken for capital account purposes in the case of residents.

    Institutional Framework

    • Replacement of the earlier Foreign Exchange Regulation Act (FERA), 1973 by the market friendly Foreign Exchange Management Act, 1999. Delegation of considerable powers by RBI to Authorised Dealers to release foreign exchange for a variety of purposes.

    Increase in Instruments in the Foreign Exchange Market

    • Development of rupee-foreign currency swap market.
    • Introduction of additional hedging instruments, such as, foreign currency-rupee options. Authorised dealers permitted to use innovative products like cross- currency options, interest rate and currency swaps, caps/collars and forward rate agreements (FRAs) in the international forex market.

    Liberalisation Measures

    • Authorised dealers permitted to initiate trading positions, borrow and invest in overseas market subject to certain specifications and ratification by respective Banks’ Boards. Banks are also permitted to fix interest rates on non-resident deposits, subject to certain specifications, use derivative products for asset-liability management and fix overnight open position limits and gap limits in the foreign exchange market, subject to ratification by RBI.
    • Permission to various participants in the foreign exchange market, including exporters, Indians investing abroad, FIIs, to avail forward cover and enter into swap transactions without any limit subject to genuine underlying exposure.
    • FIIs and NRIs permitted to trade in exchange-traded derivative contracts subject to certain conditions.
    • Foreign exchange earners permitted to maintain foreign currency accounts. Residents are permitted to open such accounts within the general limit of US $ 25,000 per year.

    Box IV: Reforms in the Monetary Policy Framework

    Objectives

    • Twin objectives of “maintaining price stability” and “ensuring availability of adequate credit to productive sectors of the economy to support growth” continue to govern the stance of monetary policy, though the relative emphasis on these objectives has varied depending on the importance of maintaining an appropriate balance.
    • Reflecting development of financial market and liberalisation, use of broad money as an intermediate target has been de-emphasised and a multiple indicator approach has been adopted.
    • Emphasis has been put on development of multiple instruments to transmit liquidity and interest rate signals in the short-term in a flexible and bi-directional manner.
    • Increase of the linkage between various segments of the financial market including money, government security and forex markets.

    Instruments

    • Move from direct instruments (such as, administered interest rates, reserve requirements, selective credit control) to indirect instruments (such as, open market operations, purchase and repurchase of government securities) for the conduct of monetary policy.
    • Introduction of Liquidity Adjustment Facility (LAF), which operates through repo and reverse repo auctions to set up a corridor for short-term interest rate. LAF has emerged as the tool for both liquidity management and also as a signalling devise for interest rate in the overnight market. Use of open market operations to deal with overall market liquidity situation especially those emanating from capital flows.
    • Introduction of Market Stabilisation Scheme (MSS) as an additional instrument to deal with capital inflows without affecting short-term liquidity management role of LAF.

    Developmental Measures

    • Discontinuation of automatic monetisation through an agreement between the Government and the Central Bank. Rationalisation of Treasury Bill market.
    • Introduction of delivery versus payment system and deepening of inter-bank repo market.
    • Introduction of Primary Dealers in the government securities market to play the role of market maker. Amendment of Securities Contracts Regulation Act to create the regulatory framework.
    • Deepening of government securities market by making the interest rates on such securities market related.
    • Introduction of auction of government securities. Development of a risk-free credible yield curve in the government securities market as a benchmark for related markets.
    •  Development of pure inter-bank call money market.
    • Non-bank participants to participate in other money market instruments. Introduction of automated screen-based trading in government securities through Negotiated Dealing System (NDS). Setting up of risk-free payments and system in government securities through Clearing Corporation of India Limited (CCIL). Phased introduction of Real Time Gross Settlement (RTGS) System.
    • Deepening of forex market and increased autonomy of Authorised Dealers.

    V. PERFORMANCE OF THE FINANCIAL SECTOR UNDER THE REFORM PROCESS
    BANKING SECTOR

    Banking sector reform has established a competitive system driven by market forces. The process, however, has not resulted in disregard of social objectives such as maintenance of the wide reach of the banking system or channelisation of credit towards disadvantaged but socially important sectors. At the same time, the reform period experienced strong balance sheet growth of the banks in an environment of operational flexibility. A key achievement of the banking sector reform has been the sharp improvement in the financial health of banks, reflected in significant improvement in capital adequacy and improved asset quality. This has been achieved despite convergence of the prudential norms with the international best practices.2 There have also been substantial improvements in the competitiveness of the Indian banking sector reflected in the changing composition of assets and liabilities of the banking sector across bank groups. In line with increased competitiveness, there has been improvement in efficiency of the banking system reflected inter alia in the reduction in interest spread, operating expenditure and cost of intermediation in general. Contemporaneously there have been improvements in other areas as well including technological deepening and flexible human resource management. A more detailed discussion on the performance analysis of the banking sector under the reform process is given below.

    Social Objectives and Balance Sheet Management
    The Indian banking system has acquired a wide reach, judged in terms of expansion of branches and the growth of credit and deposits (Tables 1 and 2). The expansion of branch network peaked in the phase of social banking during the 1970s and 1980s. Despite the slowdown in branch expansion since the 1990s, the population per bank branch, however, has not changed much since the 1980s, and has remained at around 15,000. It is often asserted that the Indian banking sector is saddled with too many branches, adding to its high intermediation costs. In fact, at about 8-10,000, the population per branch in developed countries is lower than that in India. Therefore, the reform process has maintained the gains in terms of the outreach of bank branches achieved in the phase of social banking.

    Despite a decline, direct lending to disadvantaged segments of the economy under the priority sector advances remained high during the reform period. The decline in priority sector lending since the initiation of reforms in fact reflects greater flexibility provided to banks to meet such targets. Currently, in the event a bank fails to meet the priority sector lending target through direct lending, the bank can invest the shortfall amount with the apex organisations dealing with flow of funds towards agriculture and small-scale industries. While adherence of banks to the norms on direct lending towards the priority sector still remains desirable, the current arrangement reflects how the reform process has provided operational flexibility to banks even while meeting social objectives.

    The discernible increase in the proportion of bank deposits to national income is reflective of the enhanced deepening of the Indian financial system during the period. Simultaneously, there have been considerable increases in per capita deposits and credit. This also implies an increase in the average business per bank branch, which is likely to have improved the viability of individual bank branches including those in the rural and semi-urban centres.

    In the post-reform period, banks have consistently maintained high rates of growth in their assets and liabilities. This is particularly credible given the low inflationary situation that prevailed in this period compared to the earlier periods, most notably in the 1980s. On the liability side, there has not been much compositional change since the initiation of reforms whereby deposits continue to account for about 80 per cent of the total liabilities. On the asset side, however, there is a definite increase in the share of investments. While the share of loans and advances did decline in the 1990s, it has recovered in recent years.
    Despite the large decline in SLR in the 1990s,3 the sharp increase in investments by banks is reflective of their attempt to evolve treasury operations into profit centres. The reduction in cash reserve ratio and improved inter-office adjustments in a substantially computerised and networked environment, inter alia, did free up substantial amounts of bank resources, which enabled banks to concentrate on investment operations with greater vigour.

    Interestingly, despite the reduced regulatory requirement to invest in government and other securities approved for SLR investment, the major increase in investment operations by Indian banks since the mid 1990s has been on account of their investment in government securities. This reflects the sustenance of high fiscal deficits of both central and state governments, particularly after the Pay Commission award leading to increase in the government salary bill in 1997. Furthermore, subdued industrial growth since 1997 also led to lower credit demand, providing banks further incentive to place their resources in risk-free government securities. It is also possible that, in a declining interest rate scenario in the presence of a developing debt market, this was a rational profit maximising strategy. Banks’ investment in non-SLR securities as a proportion of total assets has in fact declined since 1999-2000. While in the 1990s, greater orientation towards investment activities and aversion to credit risk exposure may have deterred banks from undertaking their ‘core function’ of providing loans and advances, banks seem to have struck a greater balance between investment and loans and advances in recent years. Improved atmosphere for recovery created in the recent years coupled with greater awareness about market risks associated with large holding of securities portfolio seem to have induced banks to put greater efforts in extending loans.

    Capital Position and Asset Quality

    A set of micro-prudential measures have been stipulated since the onset of reforms aimed at imparting strength to the banking system as well as
     
     

    ensuring safety and soundness in order to fix ‘the true position of bank’s balance sheet and…to arrest its deterioration’ (Rangarajan, 1998). With regard to prudential requirements, norms for income recognition and asset classification (IRAC), introduced in 1992, have been strengthened over the years in line with international best practices. A strategy to attain CRAR of 8 per cent in a phased manner was put in place and subsequently the level was raised to 9 per cent with effect from 1999-2000.
    The overall capital position of commercial sector banks has witnessed a marked improvement during the reform period (Table 3). Illustratively, as at end-March 2003, 91 out of the 93 commercial banks operating in India maintained CRAR at or above 9 per cent. The corresponding figure for 1995-96 was 54 out of 92 banks.4 Improved capitalisation of public sector banks was initially brought through substantial infusion of funds by government to recapitalise these banks. On a cumulative basis, infusion of funds by government into the public sector banks since the initiation of reforms for the purpose of recapitalisation amounted to less than 1 per cent of India’s GDP, a figure much lower than that for some other countries.
    Subsequently, in order to reduce pressure on the budget and to introduce market discipline, public sector banks have been allowed to raise funds through issue of equity in the market subject to the maintenance of 51 per cent public ownership. 20 out of the 27 public sector banks have raised capital from the market (Table 4). In order to improve their price-earning ratios, many public sector banks have also returned part of government’s equity subscription. Another important factor in the improvement in capital position of banks operating in India stemmed from deployment of retained earnings out of increased profits.
    The reform period also witnessed considerable improvements in the asset quality of banks. Non-performing loans (NPLs) as ratios of both total advances and assets declined substantially and consistently since the mid-1990s. Moreover, for the first time since the initiation of reforms, in 2002-03, the absolute amount of NPLs in both gross and net terms witnessed declines (Table 5). This improved recovery performance raises a few interesting issues. First, from the pattern of NPLs over the years, it can be argued that to a large extent the NPL problems faced by Indian banks are legacy problems emanating from credit decisions taken before the full implementation of the banking sector reforms. Second, there has been a distinct improvement in the credit appraisal process in the Indian banking system under the reform process whereby incremental NPLs have been low despite the fact that Indian industry has gone through a relatively low-growth phase since the mid-1990s. Finally, in recent years, the recovery performance of public sector banks has been better than private sector banks – both old and new – in terms of net NPL (i.e. net of provisioning). Foreign banks, however, exhibited the best recovery performance and lowest NPL levels among the all bank-groups. This raises a question mark on the applicability of the argument that links performance of banks with ownership pattern in the context of Indian banking.

    Another interesting point that merits mention is that despite India’s transition to a 90-day NPL recognition norm (from 180-day norm) since 2004, both gross and net NPLs as a percentage of total advances declined between end-March 2003 and end-March 2004. This reflects the success of new initiatives for resolution of NPLs including promulgation of the SARFAESI5 Act in containing NPLs. Greater provisioning and write-off of NPLs in the face of greater profitability also helped keeping the NPLs low during 2003-04.

    Competition and Efficiency
    One of the major objectives of banking sector reforms has been to enhance efficiency and productivity through enhanced competition. Such policies have led to considerable and consistent reduction in the shares of public sector banks in the total income, expenditure and assets of the commercial banking system (Table 6). Shares of Indian private sector banks, especially new private sector banks established in the 1990s, in the total income and assets of the banking system have improved considerably since the mid-1990s. A number of new private sector banks have emerged as dynamic components of the Indian banking system, reducing not only the market share of public sector banks but also those of foreign banks. The reduction in the asset share of foreign banks, however, is partially due to their increased focus on off-balance sheet non-fund based business.
    Notwithstanding such transformation, the position of public sector banks in the Indian banking system continues to be predominant as these banks account for nearly three-fourths of assets and income. It is important to note that public sector banks have responded to the new challenges of competition, which is reflected in the increase in share of these banks in the overall profit of the banking sector. From the position of net loss in the mid-1990s, in recent years the share of public sector banks in the profit of the commercial banking system has become broadly commensurate with their share of assets, indicating a broad convergence of profitability across various bank groups. This is yet another example that, with operational flexibility, public sector banks are competing effectively with private sector and foreign banks. The market discipline imposed by the listing of most public sector banks has also probably contributed to this improved performance. Public sector bank managements are now probably more attuned to the market consequences of their activities.
    Since the mid-1990s, profitability levels of commercial banks have hovered in the range of 0.7-0.8 per cent, except during certain exceptional years (Table 7). Clearly this is an improvement over the profitability prior to the initiation of the reform process. Moreover, there is a general improvement in the profitability situation in the recent years across bank groups. Since the mid-1990s, consistent with soft interest rate policies, both interest income and interest expenditure of banks as proportions of total assets have declined. However, interest expenditure declined faster than interest income, resulting in an increase in net interest income (Table 7).
    Reflecting the greater emphasis on income and expenditure management, there has been a general reduction in the operating expenditure as a proportion of total assets (Table 7). This is also reflective of efficiency gain of the Indian banking under the reform process. This has been achieved in spite of large expenditures incurred by Indian banks in installation and upgradation of information technology. Moreover, in order to address manpower redundancies, public sector banks also incurred large expenditures under voluntary pre-mature retirement of nearly 12 per cent of their total staff strength. The process, however, resulted in reduced operating expenditure in the medium-term.
    Another reflection of greater competition and efficiency of the Indian banking system can be captured from the considerable reduction in interest spread over the reform period. Once again, this reduction has been across the bank-groups. In fact, the spread is the highest for foreign banks and lowest for new private sector banks (Table 8).
    A major impact of the reform process on the Indian banking has been in terms of change in business strategy of the banks. When banking sector reforms were introduced, over 90 per cent of the income of commercial banks in India was in the form of interest income, this proportion has gone down substantially to about 80 per cent in recent years. This reflects greater diversification of banks into non-fund based business and also emergence of treasury and foreign exchange business as profit centres for Indian banks.
    Inflexibility of the Indian labour market is often identified as one of the weak points of the Indian reform process. It is, however, important to note that as a part of financial sector reforms, 26 out of the 27 public sector financial intermediaries have been successful in restructuring their workforce, which involved downsizing of the labour force by 12 per cent. Such steps have resulted in decline in staff cost and increase in business per employee.
    This brief quantitative review of the performance of the Indian banking sector documents the very significant improvements that have occurred over the decade of reforms. The performance parameters of Indian banks are now approaching international standards and they are among the better performers in the emerging market group (Table 9). As both domestic and international competition intensifies, it will be essential for Indian banks to further improve their efficiency and also deploy better their resources as fiscal dominance declines.

    Debt Market
    In nominal terms, fiscal deficit of the central government has increased substantially since the early 1990s and as a proportion of GDP it has hovered around 6 per cent. However, more importantly, the dependence of government on market borrowings has increased sharply in this period. The outstanding stocks of both Centre and State Government debt each increased by about 10 times since the initiation of reforms (Table 10). From around 20 per cent in the early 1990s, share of net market borrowing in financing fiscal deficit of the central government has increased to 80 per cent in recent years (Table 11).
    Despite such rapid increase in market borrowing and continued dominance of financial intermediaries, especially banks, in the government securities market, there has been substantial reduction in the yield as well as cost of borrowing of the Government (Tables 12 and 13). While a major part of such reductions are in line with the high liquidity phase of the global financial market witnessed in the past few years, the reduction in yield and interest rate started much earlier, indicating efficiency gains in the government securities market.
    Between the mid- and late-1990s, there has been a substantial widening of maturity profile of government securities, which has reduced the roll-over risk of government debt. Apart from reduction in yield, the dispersion of yield rate on different types of government securities has also declined considerably. These positive developments, to a large extent, reflect the improved market structure for the government securities since the initiation of reforms. Reflecting the buoyancy of the fixed-income securities market in India, despite almost secular decline in yield rate across the maturity spectrum, the turnover in the market has increased over ten-times between 1998-99 and 2003-04 (Table 14) (Mohan, 2004).

    Foreign Exchange Market
    The reforms measures in the foreign exchange market have resulted in significant deepening of the market in terms of both instruments and variety of players. Despite certain fluctuations, daily average turnover in the Indian foreign exchange market has shown a general increase. A survey by the Bank for International Settlements on the foreign exchange market turnover during 2001 in which 43 countries including India participated reveals that while foreign exchange market turnover declined the world over considerably as compared to 1998, it increased in India. The turnover has increased particularly in recent years (Table 15).
    In recent years, the turnover in the foreign exchange market has been nearly 6 times higher than the aggregate size of India’s balance of payments. While inter-bank transactions accounted for about 80 per cent of the turnover in the foreign exchange market, merchant transactions registered high growth rates in recent years. The increased turnover can be taken as an indicator of the extent of liberalisation of the Indian foreign exchange market and the consequent deepening of the foreign exchange market. Full convertibility on the current account and extensive liberalisation of the capital account transactions have facilitated not only transactions in foreign currency, these have enabled the corporates to hedge various types of risks associated with foreign currency transactions.
    Authorised Dealers (ADs) are the leading agencies in the transmission of the liberalisation measures in the context of foreign exchange market as well as widening and deepening of such markets. ADs also facilitate corporates in hedging foreign currency risk exposures. With the deepening of foreign exchange market and increased turnover, income of commercial banks through such transactions increased considerably. In recent years, profit from foreign exchange transactions accounted for 20-30 per cent of the total profit of the public sector banks.
    Despite liberalisation of the capital account and introduction of a market determined exchange rate, the foreign exchange market in India remained stable barring a few episodes of mild volatility (Table 16). Therefore, India’s current exchange rate policy of managing volatility without fixed target levels has yielded satisfactory results. It is, however, important to point out that RBI intervention in the foreign exchange market has been relatively small in terms of volume. During 2002-03, a year considered to be characterised by considerable intervention by the Reserve Bank, gross intervention by the Reserve Bank of India accounted for less than 3 per cent of the turnover in the foreign exchange market. This shows the predominant role of market forces in determination of the external value of the rupee.
    Reflecting the resilience of the Indian economy, in particular the financial sector, there has been a large inflow of funds towards the country in recent years. This has reflected in large accumulation of foreign exchange reserves (Table 17). An analysis of the sources of reserve accretion indicates that buoyancy in services exports, large unilateral private transfers reflecting mainly remittance from Diaspora, and various types of non-debt creating capital inflows have been the major source for the accumulation of foreign exchange reserves. It is interesting to note that while financial sector reforms started at the backdrop of external sector crisis, India’s foreign exchange reserves reached historical peaks when the country has substantially liberalised norms governing flows of foreign exchange. Accumulation of foreign exchange reserves also reflects monetary policy response in face of large capital inflows. The process has been successful in maintaining price stability. Available indicators of reserve adequacy suggest that India’s current level of foreign exchange reserves can be considered adequate as a cushion against potential disruptions to trade and current transactions as well as external debt servicing obligations. In the absence of an international lender of last resort, the reserves also provide the country a level of self-insurance against destabilising and costly financial crisis.

    Other Financial Intermediaries
    In line with banks, there has been an almost across-the-board improvement in the financial health of other financial intermediaries as well in terms of improvements in capital position and reduction in NPLs. Among the cooperative banks, there have been improvements in capital position, reduction in spread and operating expenses. Despite the decline in NPLs as a proportion of total assets for a majority of the cooperative banks, the ratio for some of the large cooperative banks increased significantly, mainly on account of inappropriate risk-management and corporate governance practices. Measures have been put in place to guard against repetition of such episodes, but this remains a burden.

    Capital adequacy levels of most of the major DFIs have improved while NPL levels declined since the mid-1990s. Moreover, reflecting the adaptability of DFIs to changed business environment under the reform process, the share of para-banking activities such as underwriting, direct subscription and guarantees has increased from 10 per cent in the early-1990s to over 30 per cent in recent years. Some of the DFIs, however, have not been able to adjust as well as the others in the new environment mainly because of their past investment behaviours. Moreover, a few of the large DFIs felt that they could perform better as banks under the new environment. ICICI has already transformed itself into a bank and similar moves are underway for the Industrial Development Bank of India (IDBI). There has also been a large transformation in the NBFC sector, whereby a large number of NBFCs have discontinued their public deposit taking activities.

    Under the strategy of sequenced reform, such measures in the insurance sector were introduced later than the banking sector. Despite this relatively late start, the insurance sector has witnessed considerable changes over the past few years. A large number of private insurance companies, generally with foreign capital participation, have entered the sector. The current profile of the Indian insurance industry reflects that, notwithstanding the entry of private sector players, in terms of both assets and liabilities, insurance companies from the public sector continue to dominate the industry. Despite this, given the fast pace of growth in the insurance industry, private players have been able to market their products (IRDA, 2002).
    Perhaps more importantly, liberalisation of entry norms in insurance segment has brought about a sea change in product composition. While in the past, tax incentives were the major driving force of the insurance industry, particularly life insurance industry, in the emerging situation the normal driving force of an insurance industry is taking important roles (IRDA, 2002). Driven by competitive forces and also the emerging socioeconomic changes including increased wealth, education and awareness about insurance products have resulted in introduction of various novel products in the Indian market. Along with the changing product profile, there have also been salutary improvements in consumer service in recent years, driven largely by the impact of new technology usage, better technical know-how consequent upon foreign collaboration and focused product targeting, dovetailed to specific segments of the populace as well as cross-selling of products through bancassurance. Insurance companies are also taking active steps to venture into innovative distribution channels for their products over and above creating strong agency network.

    Equity Market
    The 1990s have been good for the Indian equity market. The market has grown exponentially in terms of resource mobilisation, number of stock exchanges, number of listed stocks, market capitalisation, trading volumes, turnover and investors’ base (Table 18). Along with this growth, the profile of the investors, issuers and intermediaries has changed significantly. The market has witnessed a fundamental institutional change resulting in drastic reduction in transaction costs and significant improvement in efficiency, transparency and safety (NSE, 2003). In the 1990s, reform measures initiated by SEBI such as, market determined allocation of resources, rolling settlement, sophisticated risk management and derivatives trading have greatly improved the framework and efficiency of trading and settlement. Almost all equity settlements take place at the depository. As a result, the Indian capital market has become qualitatively comparable to many developed and emerging markets.
    The liberalisation and consequent reform measures have drawn the attention of foreign investors leading to a rise in portfolio investment in the Indian capital market. During the first half of the 1990s, India accounted for a larger volume of international equity issues than any other emerging market (IMF, 1995). Over the recent years, India has emerged as a major recipient of portfolio investment among the emerging market economies. Apart from such large inflows, reflecting the confidence of cross-border investors on the prospects of Indian securities market, since 1993, when entry of FII was permitted for the first time, except for one year, India received positive portfolio inflows in each year. The stability of portfolio flows towards India is in contrast with large volatility of portfolio flows in most emerging market economies.

    VI. ISSUES
    As the foregoing analysis suggests, there has been a structural transformation in almost all segments of the Indian financial sector since the initiation of reforms. The reform process has strengthened the health of financial intermediaries, deepened financial markets and enhanced the instruments available in the financial system. At the level of individual institutions as well as at the systemic level, there has been considerable reinforcement of the framework for stability. There have also been discernible improvements in the competitiveness, efficiency and productivity of the Indian financial system. What then are important issues facing the Indian financial system now?

    Even after one and a half decades of financial sector reforms, continued predominant public sector entities in the sector has often been a topic of debate. India’s experience in this respect is different from many other emerging market economies, especially the transition countries, where financial sector reforms resulted in privatisation of erstwhile public sector financial intermediaries. In the late 1990s, India too proposed legislative change to enable reduction in government ownership up to 33 per cent in the public sector banks. It was proposed that notwithstanding such ownership pattern change, these banks “would retain their public sector character”. The proposal, however, failed to meet parliamentary approval, indicating a lack of political acceptability on privatisation so far. Meanwhile public sector banks continue to raise capital from market and in nine public sector banks, including the State Bank of India, the largest Indian bank, private ownerships
     
     

    have become close to 40 per cent. It is also important to recall that this paper has shown that since the initiation of reforms, financial health as well as efficiency of the public sector banks closely matched and some times surpassed those of the private sector including foreign banks. Therefore, there is no definite observed link between efficiency and ownership in the contemporary Indian banking system. The competition induced by the new private sector banks has clearly re-energised the Indian banking sector as a whole: new technology is now the norm, new products are being introduced continuously, and new business practices have become common place.
    India’s approach towards treatment of insolvent banks is yet another interesting issue. Rather than closing them down, policymakers in India have shown a preference to merge such banks with healthy public sector banks. It has been felt in certain circles that such an approach may give rise to a moral hazard problem. However, two issues need consideration in this context. First, commercial banks are the most dominant and systemically important segment of the financial system. Second, over 70 per cent of the bank depositors in India are small depositors. Therefore, systemic concerns coupled with the necessity to safeguard the interest of small depositors have been paramount in the minds of policy makers while dealing with insolvent banks. This issue had not received much attention in the context of a predominantly government owned banking system. As the weight of private banks increases further thinking will need to be done on this subject, both in terms of prevention of insolvency through advance regulatory supervision and action, and post insolvency measures that discourage moral hazard and eventual fiscal cost.
    Certain banking sector and related indicators on select emerging market economies (EMEs) have been presented in Annex I. Some broad points can be drawn from these data. First, while almost all EMEs have been successful in reducing domestic inflation rates since the 1990s, most of them experienced occasional inflationary spikes in this period. Reversing the situation, in the new millennium, countries such as China and Singapore experienced deflationary situations. Along with sustained reduction in inflation during the reform period, India has been able to avoid both the extreme situations. This can be taken as an indicator of the quality of financial sector reforms and monetary management in the country. Second, though lower than most of the East Asian EMEs, India maintained reasonably high and generally rising savings and investment rates since the 1990s. Stability in the financial market under the reform process has facilitated this process. Third, compared to most other EMEs, India maintained a stable real interest rate situation under the reform process. The generally increasing trend of the real rate, however, is an issue that needs greater attention of the authorities. Various steps have already been initiated in this context. Fourth, while banks in India needed to keep high proportions of their assets as liquid assets at the start of reform process, such requirements have been relaxed in a sequenced manner. Currently, these requirements in India are on the lower side among the EMEs. Lastly, despite substantial deepening of the Indian financial system as measured by the domestic bank credit to GDP ratio and domestic credit to private sector to GDP ratio, such processes are yet to catch-up the levels of the East Asian EMEs. This is yet another area where the Indian financial sector needs to make significant strides in the coming years.
    Judged by the conventional measures such as share of foreign holdings in the Indian financial market, the extent of globalisation of Indian financial sector may look quite limited as compared to many other EMEs. Moreover, association of the authorities in the financial system either in the form of government ownership of financial intermediaries or intervention in the financial market may appear to be high. The conduct of the Indian financial sector in the face of various uncertainties and crises in various parts of the world, however, drives home the point that “On balance, there appears to be a great advantage in well-managed and appropriate integration into the global process … markets do not and cannot exist in a vacuum, i.e., without some externally imposed rules and such order is a result of public policy” (Reddy, 2003). Similar views have been expressed in the influential work of Prasad and others (Prasad et al, 2003), “The empirical evidence has not established a definitive proof that financial integration has enhanced growth for developing countries.
    Furthermore, it may be associated with higher consumption volatility. … (I)mproving governance, in addition to sound macroeconomic frameworks and the development of domestic financial markets, should be an important element of such strategies”. It is important to point out that despite the earlier apprehensions about the outcome of India’s approach of sequenced implementation of international best practices in the financial sector and gradual opening up of the sector to international competition, such measures have enabled the country to avoid major financial sector crisis experienced by many emerging market economies since the 1990s. A list of such crises is given in the Annex II and the country experiences show that premature globalisation financial market and lack of prudential framework for financial regulation and supervision have been two major reasons for financial crises in emerging market economies. Indian policy makers have been conscious of the fact that international financial market acts in a strongly pro-cyclical manner in the case of EMEs. At the same time, these countries, especially disadvantaged strata within these economies, are seriously constrained in managing the impact of such volatility. Therefore, maintenance of stability becomes a part of public policy in the emerging market countries (Reddy, 2003). Accordingly, concern for stability has been a major plank of the financial sector reforms in India. Available indicators reinforce India’s resolve for the continuance of this approach.
    Despite the considerable progress in terms of both efficiency and stability of the financial sector under the reform process, it needs to be reiterated that India has miles to go in deepening the process. Despite considerable improvements, the current level of efficiency of the Indian financial sector is far from satisfactory. Reduction in transaction costs and improving the credit delivery mechanism are two areas, which require focused attention at the current stage of reforms. There are needs for the consolidation of the banking system in India and at present there are still various institutional and legal reforms that still need attention.
    Effective implementation of corporate governance practices in financial intermediaries has been a longstanding concern of the regulators and supervisors across the world. In India too, instances of inadequacies in the implementation of corporate governance norms and disregard to prudential practices on internal control have come to light. Such instances have seriously compromised the financial health of a few private sector commercial banks and cooperative banks. Prompt corrective actions including criminal proceedings against the errant individuals have been initiated by the authorities in such cases. In order to guard against recurrence of such practices the Reserve Bank has taken various measures including implementation of important facets of international best practices in corporate governance and internal control, strengthening of the role of statutory auditors, recasting of the supervisory framework and increased disclosure to strengthen the role of market discipline. In the cooperative banking sector, continuation of multiple regulators has been identified as a major challenge before the authorities in effective regulation and supervision including implementation of corporate governance and internal control norms. The Reserve Bank has suggested jurisdiction of a single regulator to deal with this banking segment.
    Despite decline, continuation of considerable stock of NPLs in the banking system continues to be a cause for concern. Improved institutional and legal arrangements and strengthening of risk management practices by banks is likely to keep incremental NPLs low. Initiatives such as setting up of Asset Reconstruction Companies and greater emphasis on compromise settlements are likely to deal with the stock problem for NPLs. Banks may need to adopt a more pro-active approach in dealing with these issues.
    Enforcement of creditors rights will need continuous strengthening. The implementation of recent legislation will progressively be subject to judicial testing as it gets more accepted and as problems occur in its application. The legal provisions and practice in bankruptcy of the real sector are still inadequate and need further reform.
    Another area of concern relates to the decline in direct bank credit towards disadvantaged but socially important sectors such as agriculture and small-scale industries. It is felt that in the past inadequate risk management practices constrained banks to more vigorously pursue financing of such sectors. With improved risk management, it is likely that banks would deploy larger portions of their funds in these sectors. As this assessment and risk management practices improve, banks should be able to distinguish the risk quality of individual borrowers, rather than treating borrowers of a particular class as equally risky. The introduction of credit information bureau is in its infancy: the large scale availability of credit histories of borrowers at low cost is essential for better credit delivery, particularly for smaller borrowers.

    Debt Market
    The Indian debt market ranks third in Asia, after Japan and South Korea, in terms of issued amount. Outstanding size of the debt floatation as a proportion of GDP, however, is not very high in India. Moreover, although in terms of the primary issues Indian debt market is quite large, the Government continues to be the large borrower, unlike in South Korea where the private sector is the main borrower. The corporate debt market in the country is still at a nascent stage. Factors such as lack of good quality issuers, institutional investors, supporting infrastructure and high cost of issuance, market fragmentation, etc. have been identified as the reason for lack of depth of the corporate debt market in India (Mohan, 2004). However, to place India on a high and sustained growth trajectory and particularly to meet the huge financing needs of the infrastructure projects, it is necessary to develop the corporate bond market.
    As the debt market becomes larger, both for government securities and for corporate debt, its efficient functioning will depend a great deal on deepening of liquidity in the market so that trading becomes easier and more efficient. The government securities market needs to be widened much more to non-bank participants such as insurance companies, pension and provident funds, and many real sector participants who need fixed instruments for their treasury management. This will need greater trading of debt in the stock exchanges and better price discovery through anonymous, screen based, order matching systems. With increasing interest rate movement, in both directions, the efficient functioning of the debt market will also be aided by further development of the derivatives market. However, this has to be done in a careful manner, while ensuring that market participants have adequate risk management systems.
    Financial sector reforms in India were initiated early in the reform cycle. Complementary measures in other areas including fiscal and external sector provided the crucial support to the financial sector reform process. In order to deepen the financial sector reforms further, it is essential that significant reform measures are initiated in other segments of the economy including real sectors. Since the early 1990s, India as well as the world economy have undergone a structural transformation. An enduring development has been the changed perception about India – both internally and from the rest-of-the-world. While India assumes a more pivotal role in the global arena, internally the country needs to reassess the future course of restructuring process. Managing heightened expectations is going to be the major challenge of future public policy in India since, this, on the one hand, provides the country to take a quantum jump in terms of development, but, on the other hand, even a small slippage in the policy framework may prove to be the undoing of the past painstaking reform efforts. As envisaged by the 10th Plan, India is posed to attain 8 per cent per annum growth rate on a consistent basis. This was even outside the realm of wishful thinking a few years back. Appropriate sequencing and repackaging of reform measures with changed emphasis and relative speed of reforms at various sectoral levels would ultimately determine whether India would be able to leapfrog into the new growth trajectory.

    References
    Ahluwalia, M. S. (2002). “Economic Reforms in India since 1991: Has Gradualism Worked?” Journal of Economic Perspectives, 16, (3), 67-88.

    Government of India (GoI) (1998). Report of the Committee on Banking Sector Reforms (Chairman: Shri M. Narasimham), Government of India, New Delhi. Hanson, J. A. and S. Kathuria, (1999). India: A Financial Sector for the Twenty-First Century, New Delhi, Insurance Regulatory and Development Authority (IRDA) (2002). Annual Report, IRDA, Mumbai.

    International Monetary Fund (IMF) (1995). IMF Survey, IMF, Washington, D.C. Mohan, R. (2002). “Transforming Indian Banking: In Search of a Better Tomorrow”, Valedictory address at the Twenty-Fourth Bank Economists’ Conference, Bangalore, printed in Reserve Bank of India Bulletin, January 2003.

     — (2004). “A Decade of Reforms in the Government Securities Market and Agenda for the Future”, Keynote Address at FIMMDA-PDAI Conference, Dubai.

    National Stock Exchange (NSE) (2003). Indian Securities Market Review, NSE, Mumbai.

    Prasad, Eswar, Kenneth Rogoff, Shang-Jin Wei, and M. Ayhan Kose (2003). “Effects of Financial Globalisation on Developing Countries: Some Empirical Evidence”, mimeo, International Monetary Fund.
    Rangarajan, C. (1998). “Banking Sector Reforms: Rationale and Relevance”, SICOM Silver Jubilee Memorial Lecture, Mumbai.

    Reddy, Y. V. (2002). “Public Sector Banks and the Governance Challenge: Indian Experience” Paper presented at World Bank, International Monetary Fund, and Brookings Institution Conference on Financial Sector Governance: The Roles of the Public and Private Sectors, New York, USA.

    — (2002 a). “Monetary and Financial Sector Reforms in India: A Practitioner’s Perspective”, Presentation at the Indian Economy Conference, Cornell University, USA. — (2003). “Towards Globalisation in the Financial Sector in India”, Inaugural address at the Twenty-Fifth Bank Economists’ Conference, Mumbai.

    Reserve Bank of India (1991). Report of the Committee on the Financial System (Chairman: Shri M. Narasimham), Reserve Bank of India, Mumbai.

     
         
     

    Indicators

    June

    June

    March

    March

    March

    March

     

     

    1969

    1980

    1991

    1995

    2000

    2003

    1

    No. of Commercial Banks

    73

    154

    272

    284

    298

    292

    2

    No. of Bank Offices

    8,262

    34,594

    60,570

    64,234

    67,868

    68,561

     

    Of which

     

     

     

     

     

     

     

    Rural and semi-urban bank offices

    5,172

    23,227

    46,550

    46,602

    47,693

    47,496

    3

    Population per Office (’000s)

    64

    16

    14

    15

    15

    16

    4

    Per capita Deposit (Rs.)

    88

    738

    2,368

    4,242

    8,542

    12,253

    5

    Per capita Credit (Rs.)

    68

    457

    1,434

    2,320

    4,555

    7,275

    6

    Priority Sector Advances@ (per cent)

    15

    37

    39.2

    33.7

    35.4

    33.7 *

    7

    Deposits (per cent of National Income)

    15.5

    36

    48.1

    48

    53.5

    51.8

     

     

     

     

     

     

     

     

    @: Share of Priority Sector Advances in Total Non-Food Credit of Scheduled Commercial Bank,           
    *: As at end-March 2002.

    Source: Reserve Bank of India.

     

     

     

     

     

     

     
         
     

    Table 2: Select Balance Sheet Indicators of Commercial Banks Operating in India (Per cent)

     

     

     

     

     

     

    As a Ratio of Total Assets/Liabilities

     

    Deposits

    Total Investments

    Non-SLR Investment

    Loans and Advances

    1991-92

       77.7  (17.1)

    28.9 (28.4)

    ..

    46.8  (13.7)

    1992-93

    78.4 (13.9)

    30.5    (19)

    ..

    45       (8.6)

    1993-94

    80.3 (15.5)

    35.4 (31.1)

    38.7      (-3)

    1994-95

    78.9 (16.3)

    33.6 (12.2)

    4.6    (9.4)

    40.5     (24)

    1995-96

    76.4 (12.7)

    31      (7.4)

    3.5 (-11.7)

    42.1  (20.9)

    1996-97

    79.9 (17.5)

    33.3 (20.6)

    5     (60.2)

    41       (9.2)

    1997-98

    81    (19.8)

    34.2 (21.5)

    7.1  (69.3)

    40.8  (17.6)

    1998-99

    81.1 (19.7)

    35.7 (24.9)

    8.6  (45.3)

    38.8  (13.9)

    1999-00

    81.1 (16.3)

    37.3 (21.3)

    9.1  (22.4)

    40.2  (20.3)

    2000-01

    81.5 (17.7)

    38    (19.3)

    8.9  (14.2)

    40.6  (18.5)

    2001-02

    78.5 (14.3)

    38.2 (19.4)

    8.7  (16.5)

    42     (22.7)

    2002-03

    79.8 (12.4)

    40.8 (18.1)

    8.1    (3.3)

    43.6  (14.7)

    2003-04*

    80.5 (17.5)

    41.7 (19.7)

    7.2    (2.9)

    45     (15.3)

     

     

     

     

     

    *: Based on supervisory returns,

    ..: Not available,

    SLR: Statutory Liquidity Ratio.

    Note: Figures in brackets are annual growth rates.

    Source: Reserve Bank of India.

     

     

     

    Table 3: Distribution of Commercial Banks According to Risk-weighted Capital Adequacy  (Number of banks)

    Year

    Below 4 per cent

    Between 4-9 per cent*

    Between 9-10 per cent@

    Above 10 per cent

    Total

    1995-96

    8

    9

    33

    42

    92

    1996-97

    5

    1

    30

    64

    100

    1997-98

    3

    2

    27

    71

    103

    1998-99

    4

    2

    23

    76

    105

    1999-00

    3

    2

    12

    84

    101

    2000-01

    3

    2

    11

    84

    100

    2001-02

    1

    2

    7

    81

    91

    2002-03

    2

    0

    4

    87

    93

     

     

     

     

     

     

    * : Relates to 4-8 per cent before 1999-2000,

    @: Relates to 8-10 per cent before 1999-2000.

    Note : According to supervisory returns, only 2 banks failed to maintain statutory minimum CRAR of 9 per cent as at end-March 2004. Out of these two, one is scheduled to achieve the minimum CRAR level by September 2004 and other has since been placed under moratorium and merged with another bank.

    Source : Reserve Bank of India.

    Table 4: Ownership Structure of Public Sector Banks (as at end-March 2004, Per cent)

    Nationalised Banks

    Govt/RBI Share

    Share of Others

    Vijaya Bank

    53.9

    46.1

    Corporation Bank

    57.2

    42.8

    Union Bank of India

    60.9

    39.2

    Indian Overseas Bank

    61.2

    38.8

    Andhra Bank

    62.5

    37.5

    Oriental Bank of Commerce

    66.5

    33.5

    Bank of Baroda

    66.8

    33.2

    Bank of India

    69.5

    30.5

    Dena Bank

    71

    29

    Allahabad Bank

    71.2

    28.8

    Canara Bank

    73.2

    26.8

    Syndicate Bank

    73.5

    26.5

    UCO Bank

    75

    25

    Bank of Maharashtra

    76.8

    23.2

    Punjab National Bank

    80

    20

    Central Bank of India

    100

    0

    Indian Bank

    100

    0

    Punjab & Sind Bank

    100

    0

    United Bank of India

    100

    0

    State Bank Group

     

     

    State Bank of India

    59.7

    40.3

    State Bank of Bikaner & Jaipur

    75

    25

    State Bank of Travancore

    75

    25

    State Bank of Mysore

    92.3

    7.7

    State Bank of Indore

    98.1

    2

    State Bank of Hyderabad

    100

    0

    State Bank of Patiala

    100

    0

    State Bank of Saurashtra

    100

    0

    Source: Reserve Bank of India

     

     

     
         
     

    Table 5: NPL of Scheduled Commercial Banks (Per cent)

     

     

     

     

     

     

    Gross NPL/

    Gross NPL/

    Net NPL/

    Net NPL/

     

    advances

    Assets

    advances

    Assets

    Scheduled commercial banks

     

     

     

    1996-97

    15.7

    7.0

    8.1

    3.3

    1997-98

    14.4

    6.4

    7.3

    3.0

    1998-99

    14.7

    6.2

    7.6

    2.9

    1999-00

    12.7

    5.5

    6.8

    2.7

    2000-01

    11.4

    4.9

    6.2

    2.5

    2001-02

    10.4

    4.6

    5.5

    2.3

    2002-03

    8.8

    4.0

    4.4

    1.9

    2003-04*

    7.3

    ..

    3.0

    ..

    Public sector banks

     

     

     

     

    1996-97

    17.8

    7.8

    9.2

    3.6

    1997-98

    16.0

    7.0

    8.2

    3.3

    1998-99

    15.9

    6.7

    8.1

    3.1

    1999-00

    14.0

    6.0

    7.4

    2.9

    2000-01

    12.4

    5.3

    6.7

    2.7

    2001-02

    11.1

    4.9

    5.8

    2.4

    2002-03

    9.4

    4.2

    4.5

    1.9

    Old private sector banks

     

     

     

     

    1996-97

    10.7

    5.2

    6.6

    3.1

    1997-98

    10.9

    5.1

    6.5

    2.9

    1998-99

    13.1

    5.8

    9.0

    3.6

    1999-00

    10.8

    5.2

    7.1

    3.3

    2000-01

    10.9

    5.1

    7.3

    3.3

    2001-02

    11.0

    5.2

    7.1

    3.2

    2002-03

    8.9

    4.3

    5.5

    2.6

    New private sector banks

     

     

     

     

    1996-97

    2.6

    1.3

    2.0

    1.0

    1997-98

    3.5

    1.5

    2.6

    1.1

    1998-99

    6.2

    2.3

    4.5

    1.6

    1999-00

    4.1

    1.6

    2.9

    1.1

    2000-01

    5.1

    2.1

    3.1

    1.2

    2001-02

    8.9

    3.9

    4.9

    2.1

    2002-03

    7.6

    3.8

    4.6

    2.2

    Foreign banks in India

     

     

     

     

    1996-97

    4.3

    2.1

    1.9

    0.9

    1997-98

    6.4

    3.0

    2.2

    1.0

    1998-99

    7.6

    3.1

    2.9

    1.1

    1999-00

    7.0

    3.2

    2.4

    1.0

    2000-01

    6.8

    3.0

    1.8

    0.8

    2001-02

    5.4

    2.4

    1.9

    0.8

    2002-03

    5.2

    2.4

    1.8

    0.8

     

     

     

     

     

    NPL: Non-performing loans,
    *: Based on supervisory returns, ..: not available.
    Note : Bank group specific details for 2003-04 are not available.
    Source : Reserve Bank of India.

     
         
     

    Table 6: Bank Group-wise Shares: Select Indicators (Per cent)

     

     

     

     

     

    1995-96

    2000-01

                    2002-03

    Public Sector Banks

     

     

     

    Income

    82.5

    78.4

    74.5

     Expenditure

    84.2

    78.9

    74.8

    Total Assets

    84.4

    79.5

    75.7

    Net Profit

    -39.1

    67.4

    64.8

    Gross Profit

    74.3

    69.9

    76.6

    Private Sector Banks

     

     

     

    Income

    8.2

    12.6

    18.5

    Expenditure

    7.4

    12.3

    18.6

    Total Assets

    7.7

    12.6

    17.5

    Net Profit

    59.3

    17.8

    15.6

    Gross Profit

    10.1

    14.4

    18.7

    Foreign Banks

     

     

     

    Income

    9.4

    9.1

    7.0

    Expenditure

    8.3

    8.8

    6.6

    Total Assets

    7.9

    7.9

    6.9

    Net Profit

    79.8

    14.8

    19.6

    Gross Profit

    15.6

    15.7

    4.7

     

     

     

     

    Source : Reserve Bank of India.

     

    Table 7: Earnings and Expenses of Scheduled Commercial Banks (Rs. billion)

     

     

     

     

     

     

     

     

     

     

     

     

     

     

     

     

    Year

    Total Assets

    Total Earnings

    Interest Earnings

    Total Expenses

    Interest Expenses

    Establishment Expenses

    Net Interest Earning

    1951

    12

    1

    0

    0

    0

    0

    0

     

     

    (3.8)

    (3.1)

    (2.6)

    (0.9)

    (1.3)

    (2.2)

    1969

    68

    4

    4

    4

    2

    1

    2

     

     

    (6.2)

    (5.3)

    (5.5)

    (2.8)

    (2.1)

    (2.5)

    1980

    582

    42

    38

    42

    27

    10

    10

     

     

    (7.3)

    (6.4)

    (7.2)

    (4.7)

    (1.7)

    (1.8)

    1991

    3,275

    304

    275

    297

    190

    76

    86

     

     

    (9.3)

    (8.4)

    (9.1)

    (5.8)

    (2.3)

    (2.6)

    2000

    11,055

    1,149

    992

    1,077

    690

    276

    301

     

     

    (10.4)

    (9.0)

    (9.7)

    (6.2)

    (2.5)

    (2.7)

    2002

    15,355

    1,510

    1,270

    1,395

    875

    337

    395

     

     

    (9.8)

    (8.3)

    (9.1)

    (5.7)

    (2.2)

    (2.6)

    2003

    16,989

    1,724

    1,407

    1,553

    936

    3,809

    471

     

     

    (10.2)

    (8.3)

    (9.1)

    (5.5)

    (2.2)

    (2.8)

    Note : Figures in brackets are ratios to total assets.
    Source : Reserve Bank of India.

     

     

     

     

     

    Table 8: Important Parameters for Indian Banking Sector (Per cent)

     

    Bank Group

    1996-97

    2001-02

    2002-03

    Operating Expenses/Total Assets

     

     

     

    Scheduled Commercial Banks

    2.9

    2.2

    2.2

    Public Sector Banks

    2.9

    2.3

    2.3

    Old Private Sector Banks

    2.5

    2.1

    2.0

    New Private Sector Banks

    1.9

    1.1

    2.0

    Foreign Banks

    3.0

    3.0

    2.8

    Spread/Total Assets

     

     

     

    Scheduled Commercial Banks

    3.2

    2.6

    2.8

    Public Sector Banks

    3.2

    2.7

    2.9

    Old Private Sector Banks

    2.9

    2.4

    2.5

    New Private Sector Banks

    2.9

    1.2

    1.7

    Foreign Banks

    4.1

    3.2

    3.4

    Net Profit/Total Assets

     

     

     

    Scheduled Commercial Banks

    0.7

    0.8

    1.0

    Public Sector Banks

    0.6

    0.7

    1.0

    Old Private Sector Banks

    0.9

    1.1

    1.2

    New Private Sector Banks

    1.7

    0.4

    0.9

    Foreign Banks

    1.2

    1.3

    1.6

    Note : Spread = interest income-interest expenditure.

     

     

    Source : Reserve Bank of India.

     
         
     

    Table 9: Cross-Country Performance Analysis of Banks (Per cent)

     

     

     

     

     

     

     

     

     

    Country

    2001

    2002

    2003

    Latest

     

     

     

    Gross Non-Performing Loans to Total Loans

     

     

    Latin America

    Argentina1

    13.2

    17.5

    22.7

    November

     

     

    Brazil

    5.7

    5.3

    5.7

    June

     

     

    Mexico

    5.1

    4.6

    3.7

    September

    Asia

    China

    29.8

    25.5

    22.0

    June

     

     

    India

    11.4

    10.4

    8.8

    March

     

     

    Indonesia

    11.9

    5.8

    ..

     

     

     

    Malaysia

    17.8

    15.9

    14.8

    June

     

     

    Philippines

    16.9

    15.4

    15.2

    September

     

     

    Singapore

    3.6

    3.4

    3.5

    September

     

     

    Thailand

    10.5

    15.8

    15.5

    August

    Memo

    US3

    1.4

    1.6

    1.3

    September

     

     

    UK

    2.6

    2.6

    2.2

    June

     

     

    Japan

    6.6

    8.9

    7.2

    September

     

     

     

     

    Profitability of Major Banks

     

     

    Latin America

    Argentina

    -0.2

    -9.7

    -2.5

    August

     

     

    Brazil

    0.2

    1.9

    1.9

    June

     

     

    Mexico

    0.8

    -1.1

    1.6

    September

    Asia

    China

    0.1

    0.1

    ..

     

     

     

    India

    0.5

    0.8

    1.0

    March

     

     

    Indonesia

    0.8

    1.3

    ..

     

     

     

    Malaysia

    1.0

    1.3

    ..

     

     

     

    Philippines

    0.4

    0.8

    1.0

    September

     

     

    Singapore

    0.8

    0.8

    0.8

    September

     

     

    Thailand

    -0.1

    0.4

    1.1

    August

    Memo

    US 1

    1.1

    1.4

    1.4

    September

     

     

    UK 2,3

    0.5

    0.9

    0.5

    June

     

     

    Japan 2

    0.1

    0.0

    ..

    September

     

     

     

     

     

     

     

    .. Not available.
    1.With asset exceeding US $ 1 billion,
    2.Before tax,
    3.Includes mortgage banks
    Source : Global Financial Stability Report, April 2004.

    Table 10: Outstanding Stock of Central and State
    Government Securities

    (Amounts in Rs. Billion, Ratios in Per cent)

     

     

     

     

     

     

     

     

     

    1992

    1995

    2000

    2003

    2004

    Centre

     

    769

    1,375

    3,819

    6,739

    8,243

     

     

    (10.3)

    (11.6)

    (18.1)

    (27.3)

    (29.7)

    States

     

    190

    312

    739

    1,331

    1,795

     

     

    (2.5)

    (2.6)

    (3.5)

    (5.4)

    (6.5)

     

     

     

     

     

     

     

    Note:Figures in bracket are outstanding debt as a ratio of GDP at current market prices.
    Source:Reserve Bank of India.


    Table 11: Share of Market Borrowing in Financing of Fiscal Deficit of Central Government

     

     

    (Per cent)

    Market Borrowing

    Other Sources

    1991-92

    20.7

    79.3

    1992-93

    9.2

    90.8

    1993-94

    48

    52

    1994-95

    35.2

    64.8

    1995-96

    54.9

    45.1

    1996-97

    30

    70

    1997-98

    36.5

    63.5

    1998-99

    60.9

    39.1

    1999-2000

    67.1

    32.9

    2000-01

    61.4

    38.6

    2001-02

    62.2

    37.8

    2002-03

    79.3

    20.7

    2003-04

    67.2

    32.8

    Source : Reserve Bank of India.

     
         
     

    Table 12: Range of Yield by Maturity of Primary Issues

     

     

     

    (Per cent)

     

    Under 5 years

    5-10 years

    Over 10 years

    1995-96

    13.25-13.73

    13.25-14.00

    -

    1996-97

    13.40-13.72

    13.55-13.85

    -

    1997-98

    10.85-12.14

    11.15-13.05

    -

    1998-99

    11.40-11.68

    11.10-12.25

    12.25-12.60

    1999-00

    -

    10.73-11.99

    10.77-12.45

    2000-01

    9.47-10.95

    9.88-11.69

    10.47-11.70

    2001-02

    -

    6.98-9.81

    7.18-11.00

    2002-03

    -

    6.65-8.14

    6.84-8.62

    2003-04

    4.69

    4.62-5.73

    5.18-6.35

    Source :Reserve Bank of India.

     
         
     

    Table 13: Weighted Average Yield and
    Maturity of Outstanding Stock

    (Maturity in years and Yield in Per cent)

    Years

    Weighted Average Yield

    Range of Maturity of New Loans 

    Weighted Average Maturity

    Weighted average maturity of
    outstanding stock

    1995-96

    13.75

    2--10

    5.7

    N.A.

    1996-97

    13.69

    2--10

    5.5

    N.A.

    1997-98

    12.01

    3--10

    6.6

    6.5

    1998-99

    11.86

    2--20

    7.7

    6.3

    1999-00

    11.77

    5.26--19.61

    12.6

    7.1

    2000-01

    10.95

    2.89--20

    10.6

    7.5

    2001-02

    9.44

    5--25

    14.26

    8.2

    2002-03

    7.34

    7--30

    13.83

    8.86

    2003-04

    5.74

    4--30

    14.94

    9.78

    N.A. : Not available.

    Source : Reserve Bank of India.

     

    Table 14: Turnover in Government Securities Market

     

     

     

    (Rs. billion)

     

    Outstanding

    Repos

    Total

    1995-96

    176

    928

    1,272

    1996-97

    599

    254

    1,229

    1997-98

    1,185

    208

    1,857

    1998-99

    1,431

    381

    2,272

    1999-00

    4,053

    757

    5,393

    2000-01

    5,091

    1,091

    6,981

    2001-02

    11,385

    3,359

    14,744

    2002-03

    13,781

    5,635

    19,416

    2003-04

    16,852

    9,547

    26,399

    N.A. : Not available.

    Source : Reserve Bank of India.

     
         
     

    Table 15: Turnover in Indian Foreign Exchange Market

     

    (US $ billion)

    Year

    Average Daily Turnover

    1998

    5.22

    1999

    5.31

    2000

    4.74

    2001

    5.74

    2002

    5.95

    2003

    6.34

     

     

    Source : Reserve Bank of India.

     
         
     

    Table 16: Trends in External Value of the Rupee  (Per cent)

     

     

     

     

     

     

     

     

     

     

     

    Export-Based Weights

     

     

    Trade-Based Weights

     

     

    REER

    %Variation

    NEER

    %Variation

    REER

    %Variation

    NEER

    %Variation

    1990-91

    73.3

    -5.2

    66.2

    -7.6

    75.6

    -3.6

    67.2

    -6.9

     

     

     

     

     

     

     

     

     

    1991-92

    61.4

    -16.3

    51.1

    -22.8

    64.2

    -15.1

    52.5

    -21.9

     

     

     

     

     

     

     

     

     

    1992-93

    54.4

    -11.3

    42.3

    -17.3

    57.1

    -11.1

    43.5

    -17.2

     

     

     

     

     

     

     

     

     

    1993-94

    59.1

    8.6

    43.5

    2.8

    61.6

    7.9

    44.7

    2.8

     

     

     

     

     

     

     

     

     

    1994-95

    63.3

    7.1

    42.2

    -2.9

    66.0

    7.2

    43.4

    -2.9

     

     

     

     

     

     

     

     

     

    1995-96

    60.9

    -3.7

    38.7

    -8.2

    63.6

    -3.7

    39.7

    -8.4

     

     

     

     

     

     

     

     

     

    1996-97

    61.1

    0.3

    38.1

    -1.7

    63.8

    0.3

    39.0

    -1.9

     

     

     

     

     

     

     

     

     

    1997-98

    63.8

    4.3

    38.9

    2.2

    67.0

    5.0

    40.0

    2.7

     

     

     

     

     

     

     

     

     

    1998-99

    60.1

    -5.7

    35.3

    -9.3

    63.4

    -5.3

    36.3

    -9.2

     

     

     

     

     

     

     

     

     

    1999-00

    59.7

    -0.7

    34.3

    -2.9

    63.3

    -0.2

    35.5

    -2.4

     

     

     

     

     

     

     

     

     

    2000-01

    62.5

    4.6

    34.2

    -0.2

    66.5

    5.1

    35.5

    0.2

     

     

     

     

     

     

     

     

     

    2001-02

    64.4

    3.0

    34.5

    0.9

    68.4

    2.8

    35.8

    0.7

     

     

     

     

     

     

     

     

     

    2002-03

    67.9

    5.5

    35.4

    2.5

    72.8

    6.3

    37.1

    3.6

     

     

     

     

     

     

     

     

     

    2003-04

    69.7

    2.6

    34.9

    -1.5

    74.1

    1.9

    36.3

    -2.2

     

     

     

     

     

     

     

     

     

    REER : Real effective exchange rate.
    NEER : Nominal effective exchange rate.
    Note : Both REER and NEER are based on 36 country bilateral weight-based index.
    Source : Reserve Bank of India.

     
         
     

    Table 17: India's Foreign Exchange Reserves

     

     

     

     

     

     

     

    (US $ million)

    Year

    Gold

    SDRs

    Foreign Currency Position

    Total

    Reserve Position in the Fund

    Outstanding Use of IMF Credit

    Mar-93

     

    3,380

    18

    6,434

    9,832

    296

    4,799

    Mar-94

     

    4,078

    108

    15,068

    19,254

    299

    5,040

    Mar-95

     

    4,370

    7

    20,809

    25,186

    331

    4,300

    Mar-96

     

    4,561

    82

    17,044

    21,687

    310

    2,374

    Mar-97

     

    4,054

    2

    22,367

    26,423

    291

    1,313

    Mar-98

     

    3,391

    1

    25,975

    29,367

    283

    664

    Mar-99

     

    2,960

    8

    29,522

    32,490

    663

    287

    Mar-00

     

    2,974

    4

    35,058

    38,036

    658

    26

    Mar-01

     

    2,725

    2

    39,554

    42,281

    616

    0

    Mar-02

     

    3,047

    10

    51,049

    54,106

    610

    0

    Mar-03

     

    3,534

    4

    71,890

    75,428

    672

    0

    Mar-04

     

    4,198

    2

    107,448

    112,959

    1,311

    0

    Sept. 17, 2004

    4,140

    1

    112,919

    118,359

    1,299

    0

     

     

     

     

     

     

     

     

    Source:Reserve Bank of India.

     
         
     

    Table 18: Select Stock Market Indicators in India    (Per cent)

     

     

     

     

     

     

     

     

    Year (end-March)

    1961*

    1971*

    1980*

    1991

    2000

    2002

    2003

     

     

     

     

     

     

     

     

    Number of stock exchanges

    7

    8

    9

    22

    23

    23

    23

    Number of listed companies

    1,203

    1,599

    2,265

    6,229

    9,871

    9,644

    9,413

    Market capitalisation (Rs. Billion)

    12

    27

    68

    1,103

    11,926

    7,493

    6,319

     

     

     

     

     

     

     

     

    * End-December, the Stock Exchange, Mumbai only.
    Source : The Stock Exchange (BSE), Mumbai and National Stock Exchange (NSE).

    Annex I : Banking Sector Indicators of Select  Emerging Market Economies

    Table A.1 : Bank Liquid Reserves to Bank Assets Ratio

     

     

     

     

     

     

     

     

    1991

    1995

    2000

    2002

    Singapore

     

    4.1

    4.0

    2.5

    2.5

    Korea, Rep.

    6.5

    6.2

    2.0

    2.6

    South Africa

    ..

    2.9

    2.7

    2.7

    Chile

     

    6.0

    5.2

    3.1

    3.0

    Czech Republic

    ..

    12.7

    18.9

    3.8

    India

     

    16.0

    16.2

    8.0

    5.6

    Poland

     

    14.6

    7.8

    4.9

    5.6

    Philippines

     

    23.4

    11.2

    7.4

    8.5

    Argentina

     

    8.2

    3.6

    2.5

    9.5

    Mexico

     

    3.0

    22.3

    5.5

    11.1

    Indonesia

     

    9.0

    1.9

    7.0

    11.1

    China

     

    17.8

    18.0

    12.7

    12.1

    Malaysia

     

    6.4

    14.4

    13.6

    12.5

    Russian Federation

    ..

    12.0

    15.4

    13.9

    Brazil

     

    7.3

    7.7

    7.7

    23.6

    High income: OECD

    1.7

    1.5

    0.9

    ..

     

     

     

     

     

     

    Source : World Development Indicators online, World Bank.

     

    Table A.2 : Domestic Credit Provided by Banking Sector (Per cent of GDP)

     

     

     

     

     

     

    1991

    1995

    2000

    2002

    Mexico

    36.8

    42.3

    26.7

    26.6

    Russian Federation

    ..

    25.5

    24.7

    26.6

    Poland

    34.8

    32.0

    34.1

    36.2

    Czech Republic

    ..

    75.9

    54.5

    45.8

    India

    51.3

    44.3

    53.3

    58.5

    Indonesia

    45.6

    52.7

    67.4

    59.5

    Philippines

    23.9

    64.3

    66.9

    60.5

    Argentina

    22.8

    27.9

    34.5

    62.4

    Brazil

    93.8

    44.8

    49.5

    64.8

    Chile

    63.9

    60.3

    72.6

    77.6

    Singapore

    75.9

    76.0

    90.4

    84.8

    Korea, Rep.

    66.4

    64.7

    103.1

    116.9

    South Africa

    ..

    140.2

    158.4

    150.9

    Malaysia

    79.0

    126.7

    148.2

    154.2

    China

    92.6

    91.2

    132.7

    166.4

    High income: OECD

    135.3

    154.2

    175.2

    170.0

    Source : World Development Indicators online, World Bank.

     
         
     

    Table A.3 : Domestic Credit to Private Sector (Per cent of GDP)

     

     

     

     

     

     

    1991

    1995

    2000

    2002

    Mexico

    21.0

    29.3

    13.0

    12.6

    Argentina

    12.6

    20.0

    23.9

    15.3

    Russian Federation

    ..

    9.4

    13.3

    17.6

    Indonesia

    46.2

    53.5

    21.9

    22.3

    Poland

    24.0

    18.5

    27.7

    28.8

    India

    24.2

    22.8

    29.0

    32.6

    Czech Republic

    ..

    75.2

    54.0

    33.4

    Brazil

    42.7

    37.3

    34.7

    35.5

    Philippines

    21.5

    45.1

    43.8

    36.4

    Chile

    44.8

    54.4

    63.7

    68.1

    Singapore

    96.9

    106.4

    111.0

    115.5

    Korea, Rep.

    65.2

    64.7

    101.0

    115.6

    South Africa

    ..

    119.3

    138.9

    131.7

    High income: OECD

    109.5

    119.3

    138.0

    133.7

    China

    89.9

    88.3

    124.6

    136.5

    Malaysia

    ..

    124.4

    140.4

    146.1

    Source : World Development Indicators online, World Bank.

    Table A.4: Gross Domestic Savings (Per cent of GDP)

     

     

     

     

     

     

    1991

    1995

    2000

    2002

    Poland

    18.0

    22.1

    18.4

    15.7

    Mexico

    20.4

    22.5

    21.8

    18.3

    High income: OECD

    23.0

    22.4

    22.0

    18.4

    Philippines

    17.2

    14.6

    23.1

    18.8

    South Africa

    21.7

    18.9

    18.3

    19.2

    Indonesia

    33.2

    30.6

    25.6

    21.1

    Brazil

    20.5

    20.5

    20.0

    22.4

    India

    21.9

    25.3

    21.9

    22.5

    Czech Republic

    30.1

    29.3

    26.3

    25.8

    Chile

    27.0

    27.6

    23.5

    26.8

    Argentina

    16.2

    17.5

    15.6

    26.9

    Korea, Rep.

    36.8

    35.7

    31.3

    27.5

    Russian Federation

    36.6

    28.8

    38.7

    31.8

    Malaysia

    34.1

    39.7

    47.2

    41.9

    China

    38.1

    43.1

    39.0

    43.4

    Singapore

    45.1

    50.2

    48.1

    44.7

     

     

     

     

     

    Source : World Development Indicators online, World Bank.

     
         
     

    Table A.5 : Gross Fixed Capitalb Formation (Per cent of GDP)

     

     

     

     

     

     

    1991

    1995

    2000

    2002

    Argentina

    ..

    17.9

    16.2

    12.0

    South Africa

    17.2

    15.9

    14.8

    15.1

    Russian Federation

    23.3

    21.1

    16.9

    17.9

    Poland

    19.5

    18.6

    23.9

    18.6

    Mexico

    18.7

    16.2

    21.4

    18.9

    High income: OECD

    22.6

    21.2

    21.9

    19.0

    Philippines

    20.0

    22.2

    21.2

    19.2

    Brazil

    18.1

    20.5

    21.8

    19.3

    Indonesia

    27.0

    28.4

    21.8

    20.2

    Chile

    19.9

    23.9

    21.0

    21.6

    India

    22.0

    24.4

    22.0

    22.5

    Malaysia

    36.4

    43.6

    25.6

    23.2

    Singapore

    33.6

    33.4

    30.0

    25.7

    Czech Republic

    24.1

    32.0

    28.3

    26.3

    Korea, Rep.

    39.0

    36.7

    28.4

    26.7

    China

    27.5

    34.7

    36.5

    40.2

     

     

     

     

     

    Source : World Development Indicators online, World Bank.

    Table A.6 : Inflation, Consumer Prices (annual %)

     

     

     

     

     

     

    1991

    1995

    2000

    2002

    China

    3.5

    16.9

    0.3

    -0.8

    Singapore

    3.4

    1.7

    1.4

    -0.4

    Czech Republic

    ..

    9.2

    3.9

    1.8

    Malaysia

    4.4

    3.5

    1.5

    1.8

    Poland

    76.7

    28.1

    10.1

    1.9

    Chile

    21.8

    8.2

    3.8

    2.5

    Korea, Rep.

    9.3

    4.4

    2.2

    2.8

    Philippines

    18.5

    8.0

    4.4

    3.1

    India

    13.9

    10.2

    4.0

    4.4

    Mexico

    22.7

    35.0

    9.5

    5.0

    Brazil

    432.8

    66.0

    7.0

    8.4

    South Africa

    15.3

    8.7

    5.3

    9.2

    Indonesia

    9.4

    9.4

    4.5

    11.5

    Russian Federation

    ..

    197.5

    20.8

    15.8

    Argentina

    171.7

    3.4

    -0.9

    25.9

     

     

     

     

     

    Source : World Development Indicators online, World Bank.

     
         
     

    Table A.7: Real Interest Rate (Per cent)

     

     

     

     

     

     

    1991

    1995

    2000

    2002

    Russian Federation

    ..

    72.3

    -9.6

    0.4

    Malaysia

    4.4

    3.9

    1.7

    2.7

    Mexico

    ..

    15.7

    4.2

    3.4

    Czech Republic

    ..

    2.3

    6.0

    3.5

    Philippines

    5.6

    6.6

    4.3

    4.1

    Korea, Rep.

    -0.8

    1.8

    9.8

    5.0

    Chile

    6.1

    8.1

    10.2

    5.0

    Singapore

    3.0

    4.2

    1.3

    5.2

    China

    1.8

    -1.0

    4.9

    5.6

    South Africa

    4.0

    6.9

    6.8

    6.6

    India

    3.6

    6.0

    8.2

    8.7

    Poland

    -0.4

    3.8

    7.6

    10.3

    Indonesia

    15.4

    8.3

    8.1

    11.0

    Argentina

    ..

    14.2

    9.9

    16.2

    Brazil

    ..

    ..

    42.9

    50.1

     

     

     

     

     

    Source : World Development Indicators online, World Bank.

     

    Notes
    1    See, for example, Hanson and Kathuria (1999) and Reddy (2002a).
    2    In fact, in some cases, prudential norms in India have surpassed the international best practices and many of the proposals of Basel II are already under the process of phased implementation.
    3    In the early 1990s through the use of SLR and cash reserve ratio (CRR) as much as 63.5 per cent of the bank resources were pre-empted. Since the introduction of financial sector reforms these rates have been cut considerably in a sequenced manner. SLR has been reduced to the statutory minimum of 25 per cent, while CRR is currently at 5.0 per cent.
    4    Distribution of banks according to CRAR for 1995-96 given in Table 3 follows a slightly different classification where by banks have been grouped in terms of CRAR into groups of 4 to 8 per cent and 8 to 10 per cent.
    5    Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.


    Annex II : Major Financial Crises Since the 1990s

    Nature of Crises

    Reasons

     

     

    ERM crisis Of 1992-93, affected the countries under the Exchange Rate Mechanism

    The ERM crisis brought into focus the ability of speculators to precipitate a crisis and the limited ability of available foreign exchange reserves to stem the run on a currency in a world of volatile capital flows. The ERM crisis also highlighted the trade-off between monetary and exchange rate management policies under a convertible currency.

    Currency crisis in Mexico in 1994-95 which graduated into a debt crisis

    Volatile capital flows resulted in a currency crisis, which graduated into a debt crisis with the inability of the government to redeem the ‘tesebonos’, which were short-term debt instruments repayable in Pesos but were indexed to the US dollar issued by the Mexican Government.

    East Asian currency crisis which started with the collapse of the Thai Baht in July 1997 engulfed other Asian countries Like South Korea, Indonesia, Philippines and Malaysia

    The crisis reflected a typical case of structural imbalance and some major deficiencies in the affected economies. Uncontrolled capital account liberalization on the back of weak financial systems that were characterised by poor monitoring and surveillance, inappropriate policy stances such as pegged exchange rates and unlimited access to foreign currency loans for the private sector led to the crisis. Lack of timely and adequate financial assistance from the multilateral institutions, at least initially, seems to have exacerbated the crisis.

    Russian currency crisis in August 1998

    Faced with significantly large capital outflows in the face of inadequate reserves, Russia defaulted on its domestic and external debt in August 1998. It subsequently devalued its currency, thereby disrupting the international economy to a certain extent.

    Brazilian currency crisis in February 1999

    In February 1999, following months of speculative pressure and in spite of a large IMF rescue package, the Brazilian Real was devalued. Reasons included volatile capital flows and fundamental problems associated with the adoption of the Real Plan (1994) to control hyperinflation. Inadequate fiscal consolidation also led to fears of default, high interest rates, and a consequent debt spiral.

    Argentinean crisis in September 2001

    In September 2001, Argentina defaulted on almost US $ 3 billion debt owed by it to the IMF. Interactions between an unsustainable fiscal regime and the existing currency board arrangement in the face of unfavourable external developments were the most crucial elements in the Argentine crisis.

    Crisis in Turkey in 2001

    The immediate cause of crisis in Turkey in 2001 was a combination of portfolio losses and liquidity problems in a few banks, which triggered a loss of confidence in the entire banking system leading to a reversal of capital flows. The Turkish Lira was devalued by 30 per cent in February 2001 and the Government adopted a floating exchange rate regime to keep most of its reserves intact.


     
         
     

    The Pursuit of Financial Stability *

    Kishori .J.Udeshi,
    Issues related to monetary policy and financial sector continue to attract a lot of research interest all over the world and this is all the more true for emerging economies like India which are gradually integrating with the rest of the world.

    With growing financial openness, globalisation and liberalisation, financial stability issues have come to the forefront. These issues have ranged from discussions on basic issues of the definition of financial stability itself to issues of measurement, issues of choice of instruments to achieve the objective of financial stability and even issues on the degree of activism that central banks should adopt in pursuing this objective.

    Traditionally, it has been believed that monetary stability leads to financial stability. However, as the events of the 1990s show, it need not necessarily be the case. While there are complementarities between these two objectives, especially in the long run, the same need not hold in the short-run. A stable macroeconomic environment - low and stable inflation, sustained growth and low interest rates - can generate excessive optimism about the future economic prospects and often the risks are downplayed. Accordingly, episodes of financial instability often have their origins in environment of macroeconomic stability. Thus, macro economic stability need not necessarily always place an economy in financial stability in the medium/long term and central banks, therefore, now bestow a more focussed attention to the objective of maintaining financial stability. Historically, central banks have been concerned with both price stability and financial stability, albeit not at the same time (Crockett, 2004). What is rather unique since the 1990s has been a simultaneous pursuit of price and financial stability by central banks.

    Forces affecting financial stability

    The basic forces affecting financial stability are the quickening pace of technological innovation and the growing acceptance of market processes as basic determinant of resource allocation. Due to sectoral distinctions getting blurred, financial intermediaries have the ability to effectively compete in sectors beyond their domain by deconstructing and recombining risks. Further, the source of financial disturbances has become more unpredictable mainly due to integration of financial markets. Financial liberalisation has led to the emergence of financial conglomerates, cutting across not only various financial sectors such as banking and insurance, but also a number of countries. Therefore, a contagion means the problems of distant economies can become problems of our own.  The progressive opening up of the economies to external flows since 1990s has led to massive cross-border capital flows and volatile exchange rates. Sharp movements in exchange rates can have an adverse impact upon the balance sheets of both financial and non-financial entities. This is especially true for emerging economies as they usually need to resort to borrowing in foreign currencies.
    If we recall the banking crisis and the resultant financial crisis of Latin America (IMF 2004), we can broadly categorise the trigger points as: 

    • A boom in credit to the private sector, for both investment and consumption (Mexico, 1994; and Colombia, 1999). A particular form of boom and bust cycle is generated by the end of hyperinflationary episodes (Bolivia, 1986);
    • Wholesale liberalization in the absence of an appropriate and effective prudential regulatory framework (Mexico, 1994; and Chile, 1984). It is worth stressing, however, that highly regulated systems have also suffered crises (Peru, 1987);
    • Direct effects of fiscal difficulties on the domestic banking system, a factor that seems to have become an increasingly important source of strain on Latin American banks (Argentina, 2001);
    • Contagion and spillovers, where a crisis in one country induces economic agents to reassess their expectations and thus reduce investment in other countries (Argentina, 1995), or where a crisis in one country has a direct effect on economic conditions in another country (Uruguay, 2001);
    • Terms of trade shocks and movements in real exchange rates (Venezuela, 1994; and Ecuador, 1998); and
    • Political instability, unrest, and, in some cases, civil conflict.

    Deficiencies in the following areas have detracted from good banking practices and increased vulnerability to crisis in some Latin American countries:

    • Inappropriate and ineffective prudential regulation and supervision;
    • Inefficacy of bank intervention and resolution;
    • Policy-induced distortions, and, in particular, government influence over public sector banks;
    • Poor structure and composition of government finances;
    • Inadequate accounting practices, property rights, and corporate governance; and
    • Inefficiency of the judicial system and poor observance and enforcement of laws.

    Financial markets are different from other markets and therefore, greater liberalisation goes along with deeper supervision and higher degree of regulation.  This is because in financial markets the herd mentality catches up fast making markets volatile.  Any destabilisation in financial markets affects even those who are not in financial markets.  On the other hand, financial markets can drive the real economy.   Central banks, therefore, need to pursue a multifaceted approach towards ensuring financial stability through (i) payments system oversight, (ii) contingency planning against market disruption, (iii) lender of last resort (LOLR), (iv) share in procedures for financial regulation and (v) analysis and communication through reports such as Financial Stability Reviews (FSRs) (Goodhart, 2004). The importance assigned by central banks nowadays to the objective of financial stability is evident from the fact that a number of central banks have started publishing FSRs, giving their assessment of the health of the financial sector and its ability to withstand various shocks. The European Central Bank is a recent addition to this growing list of central banks that come out with regular FSR-type reports.
    At the global level, crisis prevention initiatives have prominently centred around strengthened IMF surveillance and include a number of aspects: data dissemination, greater transparency, development of standards and codes, constructive involvement of the private sector, Sovereign Debt Restructuring Mechanism (SDRM) and introduction of facilities like Contingent Credit Line (CCL).

    Financial Stability: An Indian Perspective

    In India too, financial stability has emerged as a key consideration in the conduct of monetary policy since the 1990s, consequent to the structural reforms initiated in the early 1990s, the gradual opening up of the Indian economy and the transformation of the financial system from a planned and administered regime to a market-oriented financial system.  As observed by Governor Dr. Reddy, contextually,  financial stability in India would mean (a) ensuring uninterrupted settlements of financial transactions (both internal and external), (b) maintenance of a level of confidence in the financial system amongst all the participants and stakeholders and (c) absence of excess volatility that unduly and adversely affects real economic activity (Reddy, 2004b). 

    The overall approach of the Reserve Bank to maintain financial stability is three-pronged: maintenance of overall macroeconomic balance; improvement in the macro-prudential functioning of institutions and markets; and strengthening micro-prudential institutional soundness through regulation and supervision. Monetary stability is an important precondition for financial stability and, therefore, the most significant contribution that monetary policy can make to financial stability is through maintaining low and stable inflation. Since the second half of the 1990s, inflation has been brought down to an average of five per cent per annum compared to an average of around 8-9 per cent per annum in the preceding two and a half decades. The reduction in inflation since the early 1990s has also enabled inflation expectations to stabilise. Low and stable inflation expectations increase confidence in the domestic financial system and, thereby contribute in an important way to the stability of the domestic financial system.

    Second, a number of measures have been taken to widen, deepen and integrate various segments of the financial markets in order to strengthen price discovery mechanism, lower the transaction costs and enhance the liquidity in the markets. At the same time, it is recognised that the capacity of economic agents in developing economies to manage volatility in all prices, goods or foreign exchange is highly constrained and there is a legitimate role for non-volatility as a public good (Reddy, 2004a). Accordingly, ensuring orderly conditions in the financial markets is an important aspect of the Reserve Bank's approach towards maintaining financial stability. Operating procedures and instruments of monetary policy have evolved over time to meet these objectives. For instance, with persistent capital flows, a new facility in the form of Market Stabilisation Scheme (MSS) was put in place effective April 2004. The MSS has provided the Reserve Bank greater flexibility in its market operations. Similarly, India's exchange rate policy of focusing on managing volatility with no fixed rate target, while allowing the underlying demand and supply conditions to determine the exchange rate movements over a period in an orderly way has stood the test of time. Prudent external sector management with a cautious approach to capital account liberalisation has been an important component of macroeconomic policies to ensure financial stability. Overall, the Reserve Bank's approach is to minimise volatility in the financial markets and minimise knee-jerk reactions, while focusing on price stability and the underlying inflation. The objective has been to ensure that there are no avoidable uncertainties in policy, while mitigating undue pressures on the functioning of markets without undermining market efficiency.

     

    A robust financial system is often characterised by smooth and secure payment systems and a word here about the several initiatives undertaken by RBI towards lifting the Indian payment system to global standards would be in order. While clearing houses were strengthened with MICR clearing processes, electronic clearing initiatives were undertaken through promotion of Electronic Clearing Services (ECS), Electronic Funds Transfer (EFT), establishment of an exclusive secured private network (INFINET) which serves as private geteway to the Indian financial system.  A Real Time Gross Settlement System (RTGS) has been operationalised as an effective, quick and secure system for inter bank funds transfers. Introduction of Negotiated Dealing System (NDS), a Centralised Funds Management System (CFMS) and the Structured Financial Messaging System (SFMS) are other key components that were put into the payment system. All these measures have quickened the settlement processes,  reduced risks in settlements and built confidence in the payment and settlement systems.  

     

    In the pursuit of financial stability, effective regulatory and supervisory initiatives along with a calibrated approach to financial sector liberalisation have a critical role to play. The Indian approach towards financial sector reforms has been based on pancha sutra or five principles (Reddy, 1998): (a) cautious and appropriate sequencing of reform measures; (b) introduction of norms that are mutually reinforcing; (c) introduction of complementary reforms across sectors (most importantly, monetary, fiscal and external sector); (d) development of financial institutions; and, (e) development of financial markets. The reforms have aimed at enhancing productivity and efficiency of the financial sector, improving the transparency of operations and ensuring that it is capable of withstanding idiosyncratic shocks.

    Regulatory measures:
    Keeping in pace with times, various regulatory prescriptions were being issued by the central bank from time to time. These steps are taken to basically ensure banking stability vis-à-vis exposures and risks. I shall outline some of the key measures:

    • Capital adequacy norms at 9% which is higher than the 8% international norm
    • Income Recognition and Asset Classification (IRAC) norms
    • Exposure norms – individual and group norms 15% and 40%, respectively with additional 10% in case of infrastructure funding.
    • Cap on foreign currency borrowing and lending as well as policy measures on hedging of such foreign currency loans
    • Cap on Capital market and sensitive sector exposures
    • Building up of Investment Fluctuation Reserve (IFR) to a minimum of 5% by March 2006.

    As a result of improvements in the regulatory and supervisory framework, the degree of compliance with Basel Core Principles has generally been high, and observed areas of weaknesses, primarily with respect to country risk guidelines have been addressed. Consolidated accounting for banks has been introduced along with a system of Risk-Based Supervision (RBS) for intensified monitoring of vulnerabilities. A scheme of Prompt Corrective Action (PCA) was introduced effective December 2002 to undertake 'structured' and 'discretionary' actions against banks exhibiting vulnerabilities in certain prudential/financial parameters. With liberalisation, financial conglomerates are emerging. Banks have accordingly been advised to prepare and disclose consolidated financial statements and prepare consolidated prudential reports. The inter-regulatory coordination has also been streamlined with the establishment of a monitoring system in respect of Systemically Important Financial Intermediaries (SIFIs), coupled with the establishment of three Standing Technical Committees constituted by the High Level Coordination Committee on Financial and Capital Markets (HLCCFCM) to provide a more focused inter-agency forum for sharing of information and intelligence.

    A major initiative towards preventing crisis has been the strengthening of the effectiveness of surveillance and incorporating a fresh perspective to its analysis and policy recommendations. To identify the strengths and vulnerabilities of the financial system (which includes banks, financial institutions, NBFCs, Primary dealers, and markets – forex, debt, money/call, and capital), a half yearly review based on financial soundness indicators (also known as macro-prudential indicators MPI) is undertaken. The MPI review comprises both aggregated micro-prudential indicators (AMPIs) of the health of individual financial institutions and macroeconomic indicators (MEIs) associated with financial system soundness. 

    This macro approach to financial supervision has helped the policy makers to refine their regulatory stance so as to achieve the fine balance between growth and financial stability. For instance, thanks to exhaustive data being collected under off-site surveillance, Reserve Bank could closely monitor the ratio of gross non-performing loans (NPL) to total loans which was at a high of 15.7 per cent for schedule commercial banks (SCBs) at end-March 1997. This ratio witnessed a marked decline to 7.2 per cent at end-March 2004. Net NPLs also witnessed a significant decline, driven by the improvements in loan loss provisioning, which comprises over half of the total provisions and contingencies. Also, based on the data on the maturity patterns of banks’ assets and liabilities and on the unrealised gains on the investment portfolios, RBI could regularly gauge the impact of rising bond yields on the banks’ balance sheets after taking into account the cushion available, both for the system as a whole and for the individual banks. We thus identified the outliers in the system on the basis of their capacity to withstand interest rate shock and sensitized them to take corrective steps.
     
    From financial stability perspective, issues of ownership, size and governance in banks are extremely relevant. In view of the importance of corporate governance in banks, we issued guidelines for effective corporate governance and also identified the criteria for determining the fit and proper status of owners and directors. It was also considered necessary to lay down a comprehensive framework of policy on ownership and governance in banks in a transparent manner.  Accordingly, we have placed in public domain a draft paper on ‘A comprehensive policy framework for ownership and governance in private sector banks’. The Reserve Bank has adopted a consultative approach, encouraging a debate on this issue and the draft is being reviewed on the basis of the feedback received from various quarters. 

    The stability of a financial system can be achieved only when institutions and markets function on the basis of informed decisions. In India, the banking system has witnessed greater levels of transparency and standards of disclosure. The range of disclosures have gradually been expanded over the years and presently includes a host of indicators relating to capital adequacy (Tier I and Tier II capital separately), NPAs, Government shareholding, movements in NPAs, exposure to sensitive sectors (capital market, real estate and commodities), movements in provisions for NPAs and investments as also information on corporate debt restructuring. These are being further enhanced to incorporate asset-liability management, risk management policies, concentrations, connected lending, evaluation of investment in subsidiaries, various performance measures and indicators thereof. Banks are providing information on various indicators in the form of notes to accounts and schedules in their balance sheets. Guidelines in regard to Fair Practices Code for Lenders were framed and the banks/all-India FIs have been advised to adopt these guidelines. The Reserve Bank has been taking several steps from time to time to enhance the transparency in banks’ operations by prescribing comprehensive requirements for disclosure in tune with the international best practices. In view of the added emphasis on the role of market discipline under Basel II and with a view to enhancing further transparency, banks have been advised on October 19, 2004 that all cases of penalty imposed by the Reserve Bank as also strictures/directions on specific matters including those arising out of inspection will be placed in the public domain with effect from November 1, 2004.

     

    *  Speech by  K. J. Udeshi, Deputy Governor, Reserve Bank of India at the 7th  Money and Finance Conference organised by Indira Gandhi Institute of Development Research (IGIDR) on  February 10, 2005 published in RBI Bulletin March 2005.

     
         
     
    Conclusion

    To conclude, ensuring an acceptable degree of financial stability is a never-ending process.

    Looking ahead, the vulnerability to real sector shocks has the potential to significantly affect financial stability in India. The major sources of shocks in India are very sharp increases in oil prices and extraordinary monsoon failures and other natural calamities with consequent impact on the agricultural sector, spilling over to other sectors of the economy. Therefore, the weight to financial stability in India is higher than in many other countries.

    Financial stability has moved to centre-stage nationally as well as in discussions relating to the future of the global monetary and financial system. Several factors have brought this about: the disturbing intensity and frequency of financial crises in the decade gone, the move to strengthen domestic financial systems under Basel II and the unfinished quest for the appropriate international financial architecture for crisis prevention and management.  Unlike in some countries where the responsibility for financial stability has been located in an independent authority, our approach has been to exploit the synergies that exist between the conduct of monetary policy and the function of financial regulation. Accordingly, financial stability in India is an integral responsibility of the Reserve Bank. Appropriate governance has enabled us to mitigate areas of conflict of interest even as we have reaped the benefits of (i) a deep understanding of the dynamics of India’s financial sector – which, in essence, has evolved around the Reserve Bank over the years – (ii) oversight of money, debt and foreign exchange markets and (iii) the accumulation of the technical skills associated with regulation and supervision. The experience with the tumultuous 1990s has shown that our approach has stood the test of time in ensuring a stable, vibrant and well-functioning financial system in the country. We have a well-capitalised financial system even by international standards, with low levels of loan delinquency despite our prudential standards being set tighter than international standards. Our financial markets are orderly and smoothly functioning and the ability of our financial intermediaries to deal in various segments of the financial market spectrum is improving almost continuously. Periodic monitoring and self-assessment of the quality of financial supervision is buttressed by external audits, including by the IMF. In the years ahead, we will continue to vigorously pursue the objective of financial stability by developing and refining our approach, modulating the pace and sequencing of regulatory function with the financial dynamics and benchmarking ourselves against international best practices so that our financial institutions emerge as global players and India becomes the international financial centre of the new millennium.

    References

    Crockett, A. “The Interaction of Monetary and Financial Stability”, Monetary Bulletin, Central Bank of Iceland, 2004/3.
    Goodhart, C.A.E. “Some New Directions for Financial Stability”. Per Jacobsson Foundation Lecture at Zurich, June 2004.
    Reddy, Y.V. “Financial Sector Reforms: Review and Prospects”. RBI Bulletin, December 1998.
    -------.  “Towards Globalisation of the Financial Sector in India”. RBI Bulletin, January 2004a.
    --------. “Financial Stability: Indian Experience”. RBI Bulletin, July 2004b.
    Finance & Development, IMF, September 2004
    Banking Sector Reforms- Achievements
    SHYAMALA GOPINATH*

    The role of the RBI in maintaining an environment conducive to investment and growth essentially relates to maintaining monetary and financial stability which can be achieved through an appropriate monetary policy framework, sound financial sector policies and strong external sector.

    Monetary Policy
    Structural reforms in the Indian economy since the early 1990s impacted upon the various aspects of monetary policy - its objectives, strategies and tactics. Price stability and ensuring adequate credit to productive sectors of the economy have been the twin objectives of monetary policy since Independence. The relative emphasis between these two objectives depends on the underlying economic conditions and is spelt out from time to time. Although with the introduction of the structural reforms, there has been a shift in the policy from a planned and administered interest rate regime to a market-oriented financial system, credit availability remains an important objective of monetary policy in India.
    At the same time, with the opening up of the economy since the early 1990s, financial stability has now emerged as a key consideration in the conduct of monetary policy. Monetary management has now to contend with vicissitudes of capital flows and the resultant volatility in exchange rates. A related difficulty is that whereas the distinction between short term and long term flows is conceptually clear, in practice, however, it is not always easy to distinguish between the two for operational purposes. Moreover, at any given time, some flows could be of an enduring nature whereas others could be temporary and, hence, reversible. More importantly, what appears to be short-term could tend to last longer and vice versa, imparting a dynamic dimension to judgment about their relative composition? In a scenario of uncertainty facing the authorities in determining temporary or permanent nature of inflows, it is prudent to presume that such flows are temporary till such time that they are firmly established to be of a permanent nature. The instruments and operating procedures of monetary policy have, therefore, to be constantly refined to meet the challenges thrown up by such capital flows and a market-determined exchange rate. This necessitated a complete recast of the monetary policy operating procedure by moving away from statutory preemptions and direct controls to an array of indirect instruments to modulate liquidity conditions in tune with the process of price discovery. The Reserve Bank is now able to influence the quantum of liquidity through a policy mix of open market (including repo) operations alongside changes in reserve requirements and standing facilities, reinforced by interest rate signals, through changes in the policy rates which impact the price of primary liquidity. Illustratively, in India, existing arrangements to modulate liquidity had to be supplemented with innovations such as the Market Stabilisation Scheme.

    Banking Sector Reforms
    As the economy grows and becomes more sophisticated, the banking sector has to develop pari passu in a manner so that it supports and stimulates such growth. With increasing global integration, the Indian banking system and financial system as a whole had to be strengthened so as to be able to compete.
    Until the beginning of the 1990s, the state of the financial sector in India could be described as a classic example of “financial repression”, a la MacKinnon and Shaw. While the true health of financial intermediaries, most of them public sector entities, was masked by relatively opaque accounting norms and limited disclosure, there were general concerns about their viability. Scant attention was placed on the financial health of the intermediaries. Their capitalisation levels were low. The lack of commercial considerations in credit planning and weak recovery culture resulted in a large accumulation of non-performing loans.
    Starting from such a position, it is widely recognised that the Indian financial sector over the last decade has been transformed into a reasonably sophisticated, diverse and resilient system. However, this transformation has been the culmination of extensive, well-sequenced and coordinated policy measures aimed at making the Indian financial sector efficient, competitive and stable. These measures covered prudential, competition enhancing institutional and legal and supervisory measures.
    An important feature of the move towards globalisation of the Indian financial system has been the intent of the authorities to move towards international best practices. This is illustrated by the appointment of several advisory groups designed to benchmark Indian practices with international standards in several crucial areas of importance like monetary policy, banking supervision, data dissemination, corporate governance and the like. Towards this end, a Standing Committee on International Financial Standards and Codes (Chairman: Dr. Y. V. Reddy) was constituted and the recommendations contained therein have either been implemented or are in the process of implementation. The RBI has recently prepared a Report that reviews the progress, provides the current status on the implementation and captures new developments in the field of international financial standards and codes.

    External Sector Management
    The overall objective of external sector reforms was to achieve higher growth and efficiency without exposing the system to greater vulnerability. The position of the external sector today is in marked contrast to the balance of payments crisis of 1991, when default was perceived as a real threat. As is well known even in these circumstances India did not default on any of its obligations and maintained its excellent track record of debt service. At that time reserves were down to less than US$ 1 billion and external debt was around US$ 85 billion as against the current position where reserves are more than external debt. We Indians can be proud of the fact that even during the worst currency crisis India did not reschedule, roll over or default on its obligations which is unparalleled.

    The process of opening up the Indian economy has proceeded in steady steps.

      • First, the exchange rate regime was allowed to be determined by market forces as against the fixed exchange rate linked to a basket of currencies.
      • Second, this was followed by the convertibility of the Indian rupee for current account transactions with India accepting the obligations under Article VIII of the IMF in August 1994.
      • Third, capital account convertibility has proceeded at a steady pace. We view it as a process rather than as an event. At present, the de facto full capital account convertibility for non-residents is supported by the calibrated liberalisation of transactions undertaken for capital account purposes in the case of residents.
      • Fourth, the distinct improvement in the external sector has enabled a progressive liberalisation of the exchange and payments regime in India. Reflecting the changed approach to foreign exchange restrictions, the restrictive Foreign Exchange Regulation Act (FERA), 1973 has been replaced by the Foreign Exchange Management Act (FEMA), 1999. It may not be entirely an issue of semantics that the ‘Exchange Control Department’ of the RBI has been rechristened as ‘Foreign Exchange Department’.

    What Have We Achieved ?
    How did these measures get translated into tangible economic results? While assessing the conduct of policies in recent years, one needs to take cognisance of the fact that the Indian economy witnessed a large number of shocks, both global and domestic. These shocks included a series of financial crises in Asia, Brazil and Russia besides September 11 terrorist attacks in the US, border tensions, sanctions imposed in the aftermath of nuclear tests and political uncertainties. From the vantage point of 2005, it seems that our strategy worked and worked reasonably well.

    There was a sharp fall in the average inflation rate to 5.8 per cent during 1994-95 to 2003-04, which is far below the long-run average of about 8.0 per cent during the 1970s-90s. While year-to-year inflation may vary depending upon the intensity of supply shocks, monetary policy can stabilise inflation expectations at low levels. It is necessary to underscore that the moderation in inflation has been wrought in an atmosphere of multiple challenges.

    • First of all, there have been a number of supply shocks, including the major drought of 2002-03. It is a measure of the improvement in supply management over the years that the inflation rate, at 3.4 per cent during 2002-03, was far lower than 8.1 per cent in 1987-88, the last drought year. Food article prices were, in fact, only marginally higher at 1.8 per cent than 9.0 per cent of 1987-88.
    • Secondly, it must be understood that large capital flows, although an indicator of investor confidence, also pose challenges for price stability. The Reserve Bank has been able to put in a carefully crafted monetary policy strategy to maintain orderly conditions in the financial markets, on the one hand and to ensure price stability on the other.
    • Finally, it is necessary to appreciate that inflationary expectations in the economy are also coming down.

    What had been the impact on the banking sector? The banking sector had been able to withstand various shocks and provided the foundation for a safe and sound financial infrastructure. Among various indicators, let me highlight three basic indicators:

    • There has been a significant improvement in the capital position of the banking system. As at end-March 2004 scheduled commercial banks had a capital to risk-weighted asset ratio (CRAR) of 12.9 percent.
    • Net non-performing assets of the banking system have come down (as percentage of net advances) to 2.9 per cent by March 2004 from 8.1 per cent in 1996-97.
    • Despite the fact that banks were required to follow income recognition and provisioning norms and that there was intensification of competition, the profitability of the banking system has improved to over 1.0 per cent of total assets since March 2003 from 0.2 per cent as at end-March 1996.

    No discussion on the achievement of financial sector reforms is complete without a discussion on financial stability in Indian context. Following Governor Reddy, financial stability in the Indian context could be interpreted to embrace: (a) ensuring uninterrupted financial transactions, (b) maintenance of a level of confidence in the financial system amongst all the participants and stakeholders, and (c) absence of excess volatility that unduly and adversely affects real economic activity.1 The stability of the Indian financial system has been tested on certain occasions and the financial system has proved its resilience.
    The management of the external sector is seen as another success story. Before I delve into the details of the impact of reform in external sector, consider the following broad indicators:

    • The current account deficit contracted to an average of only 0.6 per cent of GDP during 1994-95 to 2003-04 from 1.8 per cent in the 1980s. It, in fact, recorded a surplus since 2001-02 after a period of 23 years.
    • Key indicators of debt sustainability point to the continuing consolidation and improved solvency in the 1990s. The external debt to GDP ratio declined sharply from 38.7 per cent at end-March 1992 to 17.6 per cent at end-March 2004.
    • The present Indian regime of market determined exchange rate and focusing on managing volatility without any fixed target has served India well. In line with the policy preference, we have emphasised the need for non-debt flows rather than debt flows in our capital account during the 1990s.
    • We now have foreign exchange reserves of over US$ 130 billion, which is the sixth largest in the world, which is a far cry from the situation of August 1991 when foreign exchange reserves dwindled to US$ 0.8 billion. Our foreign exchange reserves are, in fact, larger than our external debt.

    It is now well recognised that the Indian approach to exchange rate management with a focus on managing volatility has stood the test of time. The Indian approach to exchange rate management has been even described as an ideal for Asia.
    The merits of our cautious approach to capital account convertibility are now well appreciated. Gradualism in liberalisation implies that the mix between controlled, regulated and liberalised capital transactions keeps changing gradually in favour of the latter. We did not have to reverse policies towards the capital account as was the case with some emerging market economies that had followed a relatively rapid liberalisation without entrenching the necessary preconditions. We have repeatedly emphasised that our approach to capital account convertibility is a process rather than an event, contingent on achieving certain preconditions related to health and strength of the financial sector, sustainability in the fiscal sector and containment of inflation. Over the years, the policy regime in regard to capital account inflows and outflows in India has witnessed a significant liberalisation. There are, however, two areas where extreme caution continues to be exercised, viz., (i) unlimited access to short-term external commercial borrowing; and (ii) providing unrestricted freedom to domestic residents to convert their domestic bank deposits and idle assets (such as, real estate).

    Avenues For Investment in India
    Having talked of the success story of reforms let me now turn to the avenues of investment in India. Several such options are available, depending on the risk and return profile of the investment in mind. Instead of providing a shopping list, let me give a quick rundown of the menu available.

    One of the oldest avenues is the NRI deposit. Since the early 1970s, when the Non-Resident (External) Deposit Scheme was introduced, the Reserve Bank has offered various facilities for non-resident Indians in the form of deposit schemes. Since the 1990s, the Reserve Bank’s policy in this regard has been aimed at attracting a stable pool of NRI deposits for providing a support to balance of payments. NRI deposits, at US$ 33.3 billion as at end-March 2004, emerged as a major source of capital inflows during the 1990s. Apart from the size, the success of the policy is also reflected in an increase in the proportion of local currency denominated deposits from around one-fourth in 1991 to almost two-third by 2002. This has been accompanied by a rationalisation of interest rates on rupee-denominated NRI deposits. This apart, we are now linking interest rates on foreign currency denominated deposits to LIBOR. The Reserve Bank has been de-emphasising short-term (up to 12 months) foreign currency denominated deposits in view of its attendant implications. These measures have been counterbalanced by several incentives to accord NRIs operational flexibility. Funds of US$ one million can be remitted through authorised dealers after payment of taxes subject to certain limits in case of property. Authorised dealers (ADs) are now permitted to grant rupee loans to NRIs. Earlier, housing loans availed by NRIs/Persons of Indian Origin (PIOs) could be repaid by borrowers either by way of inward remittances through normal banking channels or by debit to NRE/ FCNR(B)/NRO/NRNR/NRSR accounts or out of rental incomes derived from the property. Since May 2004, borrowers’ close relatives in India are allowed to repay the instalment of such loans, interest and other charges directly to the concerned ADs/ housing finance institutions through their bank accounts.

    A second avenue is foreign portfolio investment. We now provide an operating environment which is now much more congenial because of procedural changes for investment and facilities for investment in equity securities as well as in debt securities. NRIs and PIOs are also permitted to invest in shares and debentures of Indian companies, government securities, commercial papers, company deposits and mutual funds. An NRI is permitted to purchase/sell shares and/or convertible debentures of an Indian company through a registered broker on a recognised stock exchange provided his/her transactions are routed through designated branch of an AD in India subject to prescribed limits. Although the aggregate paid-up value of shares of the company purchased by NRIs should not exceed 10 per cent of the total paid-up capital and convertible debentures, respectively, the ceiling can be raised to 24 per cent if a Special Resolution to that effect is passed by the concerned company. NRIs are allowed to invest in exchange traded derivative contracts approved by the SEBI out of rupee funds held in India on a non-repatriable basis.

    Yet another avenue is foreign direct investment. It will be recalled that a major policy thrust towards attracting foreign direct investment (FDI) was outlined in the New Industrial Policy Statement of 1991. Since then, continuous efforts have been made to liberalise and simplify the norms and procedures pertaining to FDI. At present, FDI is permitted under the automatic route subject to specific guidelines except for a small negative list. To put this in perspective, let me mention the so-called negative list: There are just six sectors where investments are prohibited. These are: Retail trading, atomic energy, lottery business, gambling and betting, housing and real estate business and agriculture (excluding floriculture, horticulture, development of seeds, animal husbandry, pisiculture and cultivation of vegetables) and plantations (excluding tea plantations).
    There are twelve  sectors where investments require prior approval of the Government. These are:
    Domestic airlines, petroleum sector, investing companies in infrastructure and services sector, defence and strategic industries, atomic minerals, print media, broadcasting, postal services, courier services, establishment and operation of satellite, development of integrated township and tea sector.
    Further, under the automatic route, investments only in six sectors are subject to sectoral caps. These are: Private sector banking, insurance, telecommunications, trading, exploration and mining of diamonds and precious stones and airports. (Since the speech was made in January 2005, changes have been announced by the Union Finance Minister in February and March 2005.)

    Until recently, acquisition of shares from residents by non-residents through private arrangement required Government approval. Such acquisition of shares, except in financial services sector, by private arrangement no longer requires Government approval. This implies that FDI is virtually welcome in a number of sectors without any prior approval. Non-residents are permitted to enter into forward sale contracts with ADs in India to hedge the currency risk arising out of their proposed FDI in India. Non-resident shareholders were allowed to apply for issue of additional equity shares or preference shares or convertible debentures over and above their rights entitlements. Allotment is subject to the condition that the overall issue of shares to non-residents in the total paid-up capital of the company does not exceed the sectoral cap. FDI by NRIs, however, continues to be negligible.

    So far I have not mentioned about the role of remittances. During 2003-04, remittances amounted to around US$ 22.8 billion. In fact, of the Asian countries, apart from India it is only the Philippines that is receiving remittances in excess of 3 per cent of GDP. I compliment the Indian Diaspora for being such a source of resilience to the Indian economy. This apart, in view of demographic challenge facing the Western countries, remittances have an additional dimension. To the extent that they are essentially in the nature of family maintenance transfers they are surely funding a non-trivial population of the aged. For the recipient countries, remittances have the potential of reducing the pressure of dependency ratios and increasing growth. It is also good for the remitting countries, facing the old-age challenge, through augmentation of their work force.

    Concluding Observations
    India has come a long way from the days of crisis of the early 1990s. Our pragmatic and gradual approach to reform seemed to have paid reasonably well. We emerged almost unscathed from various crises like East Asian crisis, drought or sanction-like situation. While I am not being complacent, there are reasons to believe that India would be on a higher growth trajectory in the coming decades. This is echoed in the assessment of international agencies as well.
    What are the opportunities and challenges? There are business opportunities in the traditional sector – such as power generation and roadways – as well as in the sunrise sector – such as information technology. The Tenth Five Year Plan targets, among others, agriculture, and construction for high growth in view of their potential for employment generation with relatively low capital intensity. It also plans to fill the existing shortfalls in investment in power generation and communication by a significant improvement in private investment, and by removing fiscal constraints as well as generation of internal resources by the public sector. There is a particular accent on developing infrastructure which is often recognised as a major constraint on growth. Power sector reforms are energising power generation to meet the rising demand for electricity.

    The aggregate of remittances and non-resident deposits is quite significant. We now look for greater contribution in this national metamorphosis for mutual benefit. There is no doubt that the emergence of the Indian economy on a high growth path provides ample scope for the entrepreneurial abilities of the NRIs. It is only appropriate to conclude that this session will be very fruitful in discussing investment opportunities available in the Indian economy.

    1     Reddy, Y. V (2004): “Financial Stability: Indian Experience”, Lecture at Zurich University, Zurich, Switzerland, RBI Bulletin, July.


    *     An Edited Version of Keynote Address entitled “Investing in India : Challenges and Opportunities” by Smt. Shyamala Gopinath, Deputy Governor, at the sectoral session on Finance for the Pravasi Bhartiya Divas on January 8, 2005 at Mumbai.
     
         
     

    From RBI to Finance Ministry: Memoirs of Finance Manager!
    Review by Shri.S.Venkitaramanan.*

    Mr.M.Narasimham’s recent book From Reserve Bank to Finance Ministry and beyond some Reminiscences is extremely interesting and instructive too. It is an inestimable contribution to the economic history of India. Written in his usual limpid style, he translates dry as dust economic subject matters into fascinating memoirs. His skills as a raconteur are fully in evidence in these brief too brief - reminiscences.
    Mr. Narasimham was in a position to interact directly with the Governor and other senior RBI officials. He recalls how, in a report on the Bank of France that he prepared for the Governor at the latter’s instance, he commented on the independence of that institution. He commented on the independence of that institution. He noted that Napoleon himself had said that he wanted it to be” independent, but not too much”.
    Mr Narasimham notes how the US Congressional Committee - the Douglas Committee – had also recommended that the Federal Reserve should have autonomy within the Government. This concept of autonomy of central banks, but within the Government structure, continues to be part of current conventional wisdom. There cannot be two centres of economic power in a society.
    During his time in the RBI, Mr Narasimham contributed a number of ideas, some of which later blossomed into full institutions. He played a role in the evolution of the IDBI. In a paper produced at Governor Rama Rau’s instance on the utilization of the so-called Cooley funds generated as a result of PL-480 operation, he suggested to the Governor that these funds might be utilized to set up a refinancing agency, which led to the setting up of the Refinancing Corporation, whose functions subsequently got merged with the Industrial Development Bank of India.
    Following a trip to France in 1955, Mr Narasimham seems to have also laid the foundation for the close involvement of the RBI with the national Plan objectives. His study of the French system led to the credit authorization scheme, under which the RBI started approving all loans issued by commercial banks over certain limit. This scheme has since been discontinued.
    Mr.Narasimham admits that subsequent developments showed that this system of authorization lent itself to abuse and bureaucratic delays. The National Credit Council was another idea that Mr Narasimham initiated and which has disappeared over time. It may well be that such a Council consisting of leading economists, industrialists and representatives of States can play a useful role even today.
    While working in the RBI, Mr Narasimham interacted closely with the Government of India. Naturally, his abilities attracted the attention of the higher authorities and soon he was drafted to work in the Government. In 1972, he became an Additional Secretary in the Ministry of Finance, Department of Economic Affairs. He gives a graphic description of his engrossing work in this critical position, which in involve close interactions with his Ministers, including Mr Pranab Mukherji and the late Mr C.Subramaniam as also the then Prime Minister, Indira Gandhi.
    One of his contributions during this period as Additional Secretary/Finance, which evolved from a discussion with Mr.C.Subramaniam, was the suggestion to set up Regional Rural Banks, combining as they do the resources of commercial banks with local equity, regional initiative and locally available personnel. The Regional Rural Banks have not been as successful as he hoped. But the defect may proved to be pioneers, but the general impact has not been as revolutionary as it architect expected.
    In his tenure as Additional Secretary, Mr Narasimham seems to have generated even more radical changes. It is thus that we owe to Mr Narasimham the introduction of a trade-weighted basket of currencies to determine the exchange rate. This scheme, which held sway till the reforms of 1992, marked a step in the move of the country from exchange rate pegged to the sterling to its current state of being determined by the market.
    One of the unrealized suggestions of Mr Narasimham, which again arose from a query of the late Mr.C.Subramaniam, was regarding the establishment of a National Development Bank, which would draw funds from the Budget as well as from the Market and approve proposals for infrastructure projects based on a professional evaluation of viability.
    The then Deputy Chairman of thee Planning Commission, Mr.P.N.Haksar, was indeed, perspicacious when he responded to Mr Narasimham’s proposal stating that his Cartesian logic had little scope  for success in the “ real world of CMs”. These difficulties in the real world of Chief Ministers and State politicians is amply borne out by the difficulties faced by the Infrastructure Development Finance Corporation which, in sense, is a reincarnation of Mr. Narasimham’s National Development Bank.
    It may be recalled that as Chairman of the two Committees on the financial system, Mr Narasimham recommended the dismantling of the priority credit system – a system that he himself had a hand in introducing. Special interest attaches to the competent manner in which he piloted the intricate negotiations with the IMF on the 1981 loan request made by the Government. It may be recalled that there was considerable criticism of this loan, particularly among Leftists. This followed the extensive public debate, which was catalysed by the scoop of some important correspondence between Government of India and the Fund.
    This appeared in The Hindu at that time and became the subject matter of considerable public criticism. Mr.Narasimham’s reminiscences give a graphic recital of the various negotiations and the circumstances that let to the Government’s request following the oil price increases of the late 1970s and the pressure on the balance of payments. He, however, dismisses the leak of the correspondence as having been traced to an Indian staffer of the Fund.
    Ironically enough, Ashok Mitra’s strong critique on the loan itself came of use to Mr Narasimham, who utilized its points to persuade the Fund management to relax on their conditionalities. Mr. Narasimham reflects that, as it turned out, India did right in approaching the Fund at the time it did and before the BoP got into a mess. Mr Narasimham graphically explains how the US decided to abstain from approving the loan, mainly because of its belief that India should have approached the international capital market instead of borrowing from the IMF.
    This stance of the US authorities was mainly because of pressure from international banks, which had abundant resources. The US was, however, clearly wrong in trying to push India in this direction. Subsequent events in Mexico and Brazil demonstrated the dangers of excessive resort to commercial borrowings. As Narasimham points out, India’s stance in favour of a reasonable blend of multilateral borrowing and financial credit proved to be right in the light of later events.
    Further, the fact that India approached the IMF before it got into a deep crisis was a feather in the cap, not only for India’s economic statesmanship, but also for the Fund. Mr Jacques De Larosiere, Managing Director of the Fund at the time, and whom I had occasion to meet in 1992 (he was Governor of the Bank of France), recalled with a sense of pride IMF’s loan of 1981 as an achievement of his tenure. He referred in complimentary terms to the competent handling of negotiations by Mr.Narasimham and his team.
    Subsequent to his voluntary retirement from Government service and his work as Principal of the Administrative Staff College of India, Hyderabad, Mr Narasimham served  for a term in ADB, Manila, where he was Vice-President/Cooperation. He served in this capacity for just three years, though ADB’s top management was keen that he continue. I recall how Mr Fujioka, then President of the ADB, contacted me as India’s Finance Secretary in 1985, regarding the selection of a substitute for Mr Ashok Bambawala, who was retiring as Vice –President. Mr.Fujioka was insistent on Mr Narasimham, though the Government, at the political level, suggested some other names in addition. Mr.Narasimham’s was the only name Mr Fujioka would consider. Both he and the Japanese Finance Ministry had immense respect for and faith in Mr.Narasimham’s abilities.
    It goes without saying that in his short period of service in the ADB, he made a mark, in particular in extending its lending role to China and India. Mr.Narasimham’s tenure in ADB is still remembered for his contributions by many of his associates in the ADB and the countries he helped with his visionary policies and helpful attitude.
    One of the quips for which Mr.Narasimham is famous is that whenever India meets a problem, it sets up a Committee and starts an institution. In this context, it is fair to point out that Mr.Narasimham has himself been the key figure behind the formation of a number of Committees and has himself created many institutions, many of which have turned out successful.
    The Narasimham Committee – I and Narasimham Committee – II on financial reforms are his latest and crowning contributions. But Mr. Narasimham rightly refers to another Committee set up in the late 1980s, of which he was Chairman, established to look into the question of substitution of physical controls by tariffs.
    As Mr Narasimham mentions, the bold recommendations of this committee, if implemented, would have led to a more rapid liberalization of India’s economy. They represented an important step in the evolution of India’s thinking on economic reforms and in a way prepared the ground for Dr. Manmohan Singh’s won reforms in 1991.
    Mr. Narasimham is right in saying that Dr.Manmohan Singh would have done well to link his reforms with the recommendations of this Committee on physical controls. This would have helped silence the criticism that they were videsh in origin and forced on India by Bretton Woods. But reformers have their own political compulsions.


    A Salute to Reformers *
    By.V.K.Srinivasan

    Even as the nation finds itself at the cross roads while see king its economic destination, and as policy and decision makers are caught in two minds on the substantive aspects of the future course of economic reforms, two of the most influential financial administrators Sri.M.Narasimham and Dr.C.Rangarajan have offered retrospectives on the reforms polices and programmes they had helped shape in the nineties. It is well known that Sri.M.Narasimham chaired the Committee on Financial Systems (1991) and the Committee on Banking Sector Reforms (1998) and that Dr.C.Rangarajan was the Chairman of the High Level Committee  on Balance of Payments (1992)
    A grateful nation has already acknowledged the significance of their contributions by conferring Padma Vibhushan on M.NarasimhaM last year and Dr.C.Rangarajan this year. Both of them are highly respected for their maturity and balance as also for their intellectual sharpness, analytical clarity, lucidity in their presentation of policy options on the complex economic and financial challenges the nation has been facing.
    While both of them are sons of judges, were educated in Madras and have been governors of the Reserve Bank of India, their professional careers show a nice contrast. Narasimham started his career in the RBI, moved to the Ministry of Finance and shaped its policies and later represented the country on the boards of International Monetary Fund and Asian Development Bank before settling down to his quasi-academic assignment in the Administrative Staff College of India. Dr.Charkravarthy Rangarajan, on the other hand, started as an academic and taught at Jaipur, Chennai and Ahmedabad. He was with Wharton School of Business in the United States. He later served the RBI and Planning Commission before moving to the Raj Bhavan in Hyderabad. Coincidentally enough they are ‘neighbours’ now, while the ASCI turns its back to the Hussain Sagar, Raj Bhavan faces it!
    Narasimham availed the recent occasion of the release of the book, “Economic Reforms, Development and finance”, a collection of his speeches published by UBS Publications, Delhi, to make a terse statement on economic reforms, drawing attention to its character as a process, and not an event and calling for a mid-course correction of policy content, with greater attention to agriculture and small industry, Dr.Rangarajan took the opportunity of his Republic Day address to emphasize the need for policy makers to focus attention on agriculture in view of the significant contribution it can make to broad based growth, employment generation and reduction in poverty. In doing so, both these prime movers in policy making in the past  have sought to meet the well founded criticism that the reforms in the nineties have bypassed agriculture and the rural sector.
    It is also significant that there is convergence in their views that the ‘State’ and the ‘Market’ need not be viewed as competing forces but as complementing ones. While the role of the State, as a producer of commercial goods and services, as a producer of public goods and services and as a regulator of the market forces have been enumerated with conceptual elegance, one must point out that the withdrawal of the State from area of services and of the State from area of services and of the public sector from commercial and strategic sectors of the economy areas has not been smooth in India and has on the other hand been criticized as cases of “privatization of assets created with public funds”. Disinvestment has been marked by delays and proceeds from it too far meagre for meeting any useful purpose. That the poor and vulnerable sections need social safety nets has been recognized by advocates of reforms but there is as yet no credible scheme of insurance or logic in the levy of user charges. In the social sector, particularly in the areas of education and health, the approach is marked by ambivalence. Corporate governance and labour law reform are  areas in which policy markers are not able to move with sure feed.
    As Finance Minister Yashwant Sinha has been pointing out, the Second Generation reforms have been marked by contentious issues and political consensus has been difficult to reach.
    The financial and banking sector reforms would have been equally difficult had it not been for the circumspection and confidence with which issues like banking restructuring and currency convertibility were handled by Narasimham and Dr.Rangarajan. They both deserve a salute for this.

    SAFETY & SOUNDNESS STANDARDS  :
    MIGRATION TO BASEL –II
    P.R.Gopala Rao *

    • Why a new frame work?

    This is what the ‘Guru’s’ have to say :-

    Alan Greenspan , Fed Chairman

    • “Markets are not static, and changes must be made from time to time to fulfill the objectives of the law and public policy. All the factors—Unintended consequences, balancing burdens and benefits as well as the need for and cost of change-enter the calculus for the implementation of the proposed new Basel Capital Accord” (March 11 , 2005 in Texas)

    Hector Sants, Head of Fin. Services , Authority of U.K.

    • “Basel 2 updates and, in part, replaces the earlier standards. However, it goes much further than earlier standards in a number of ways. Basel 2 recognizes more explicitly than previous standards that capital is only one aspect of sound prudential standards.” (July 15, 2004 in London/ UK)
    • Is it a Different Ball Game?

    The game is more exiting now…..calls for more energy, may be more steroids.

    • Basel-1 has served a useful purpose for long but has outlived its utility
    • In 1988, when first introduced Basel -1 was a major accomplishment.
    • Basel-1 was the result of the situation of distinct and different capital adequacy requirements in different countries raising significant competitive as well as safety-and-soundness issues.
    • There was need for common definitions & minimum standards for regulatory capital and the Basel-I contained acceptable definitions of CAPITAL & RISK WEIGHTED ASSETS
    • It reflected agreement on a reasonable CRAR- the now famous 8%
    • The Basel-I measurement however, had a Straight Jacket approach and is no longer compatible with the emerging complex global banking and more sophisticated risk management practices.

    3. Is BASEL – II a way forward?

    • Basel II was ushered in to address the concern that Basel –I regulatory capital ratios are no longer good indicators of risk undertaken by large-sized banks.
    • The model is built on the current frame work of Basel I
    • Aligns more closely the regulatory Capital requirements with underlying risks
    • Provides banks & bank supervisors with several options for assessment of capital adequacy
    • The start date is January 1, 2007 and comes into full force on January 1, 2008.

    4. BASEL II IS BASED ON THREE (3) MUTUALLY REINFORCING PILLARS

    • Minimum Capital –Pillar I
    • Supervisory Review – Pillar II
    • Market Discipline – Pillar III

    The Three (3) pillars aim at

    • Comprehensive coverage of risks
    • Enhancing risk sensitivity of capital requirements
    • Providing a menu of options to choose for a refined measurement of capital

    5.A Pillar-1 Minimum Capital Requirements

    • A quantification of the risks arising from a bank’s credit, trading and other operations

    5.B. Pillar-2 Supervisory Review

    Pillar -2 envisages establishment of a strong constructive dialogue between a bank and the regulator on the risks , the risk management and capital requirements of a bank.
    Pillar-2 sets out Four (4) Key Principles of Supervisory Review

    • Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
    • Principle 2: Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.
    • Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.
    • Principle 4 : Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of the particular bank and should require rapid remedial action if capital is not maintained or restored. 

     

    5.C. Pillar-3 Market discipline

    • Robust requirements on Public disclosure intended to give the market a stronger role in ensuring the banks hold an appropriate level of capital.

    6. Approaches for Capital Assessment
    Capital needs to cover
    i) Credit Risk   (ii) Market Risk   (iii) Operational Risk.

    • AAA - There are  three (3) distinct options for computing capital requirement for CREDIT RISK and
    • Three (3) other options for computing capital requirement for OPERATIONAL RISK and

    The approaches for credit & operational risks are based on increase in risk sensitivity and allows a bank to select an approach that is most appropriate to the stage of development of it’s operations.

    • Two (2) methodologies for capital change for MARKET RISK.

    7. The approaches available for Credit Risk are…

    • Standardized Approach (SA)
    • Foundation Internal Rating Based Approach (FIRB)
    • Advanced Internal Rating Based (AIRB) approach

    8.Capital charge for Market Risk —Approaches

    • The Basel Committee has suggested two (2)  broad methodologies for computation of Capital charge for market risks
    • One is the standardized method (SM and the other is the bank’s Internal Risk Management model (IRM)
    • To start with most of the banks may adopt the “Standardized Method (SM)”

    9.Approaches available for computing capital for OPERATIONAL RISK are…

    • Basic Indicator Approach (BIA)
    • Standardized Approach (SA)
    • Advanced Measurement Approach (AMA)

    10. Most of the developing countries may start with

    • Standardized approach for Credit Risk
    • Basic Indicator approach for Operational risk
    • Standardized Method for Market risk
    • Many banks may implement the accord from 2007 with parallel runs starting from 2006
    • May have to apply uniformly to all the commercial banks

    11. Capital Funds

    • Should maintain a minimum CRAR on an ongoing basis (not below 8 %)
    • Capital Funds to be classified as Tier 1 & Tier 2

     

    TIER 1:
    i)   Paid –up capital, statutory reserves & free reserves
    ii)  Capital Reserves representing surplus arising out of sale proceeds of assets

    TIER 2 :

    • Undisclosed reserves & cumulative Perpetual Preference Shares {PPS} (those similar to equity)
    • PPS to be fully paid –up & not available for redemption by the holder
    • Revaluation Reserves at 55% discount in Tier 2 capital
    • General Provisions & Loss reserves (Loss Reserves  If available to meet unexpected losses)
    • Hybrid debt instruments: If they are able to support losses on an on going basis
    • Subordinated debt: Instruments should be fully paid-up, unencumbered and not redeemable by the holder.
    • Investment Fluctuations Reserve (IFR) is to be treated as Tier – 2 capital

     
    12 (i)Capital for Credit Risk

    • Under the standardized approach, the rating assigned by the external credit rating agencies will largely support the measure of credit risk.

    Risk Weightage – Mapping

                Rating                           Risk Weightage
               
                AAA                             20%
                AA                                50%
                A                                  100%
                BBB (and below)           150%
                Un-rated                        100%
               
    Off-Balance Sheet Items: Based on “Credit Conversion factor”

    Credit Risk Mitigation
    The revised approach allows a wide range of credit risk mitigants to be recognized for regularatory capital purposes – a significant change over the 1988 frame work.

    • It is a Comprehensive approach, allowing fuller offset of collateral against exposures by effectively reducing the exposure amount by the value ascribed to the collateral.

     

    12.(ii) Capital Charge for Market Risk
    Market risk is defined as the risk of losses in on-balance sheet and off-balance sheet positions arising from movements in market prices.
    The Market risk positions subject to Capital charge requirements are:

    • i) The risks pertaining to interest rate related instruments & equities in the trading book and
    • ii) Foreign exchange risk
    • Banks need to manage the market risks in their books on an ongoing basis and ensure that the capital requirements for market risks are being maintained on a continuous basis i.e., at the close of each business day.
    • Banks need to mark to market their trading positions on a daily basis
    • Banks need to maintain strict risk management systems to monitor & control intra-day exposures to market risks.
    • The Minimum Capital requirement is expressed in terms of two (2)separately calculated charges viz Specific charge & general market risk charge.
    • The specific change relates to any down grading of the issues( equivalent to credit/ default risk)
    • The General Market risk charges are designed to capture the risk of loss arising from changes in market interest rates.

    ·    ·   Computing the total capital charge for market risks
    The calculations need to be plotted in the following table:
                Risk Category                                       Capital Charge (in crores of Rupees)

    • Interest Rate (a + b)
      • General market risk
      • Specific Risk
    • Equity (a + b)
      • General market risk
      • Specific Risk
    •  Foreign Exchange & Gold
    • Total Capital charge for 

          Market risks (I + ii + iii)

    12 (iii)Operational Risk - Capital Charge
    Definition:

    • Risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or external events
    • Spectrum of approaches
      • Basic indicator Approach (BIA)
      • Standardized approach (SA)
      • Advanced Measurement Approach (AMA)

    Measurement Methodologies

    • To begin with, banks may compute capital requirements under the BASIC INDICATOR APPROACH (BIA)
    • Central banks need to review the capital requirement produced by the BIA for general creditability and if it is lacking, appropriate Supervisory Action under Pillar 2 will be called for.

    BIA
    Banks must hold capital for operational risk equal to the average over the previous three (3) years of a fixed percentage of positive annual gross income.

    • If there is any distortion in a bank’s Pillar -1 Capital Charge, it will call for supervisory action under Pillar  - 2
    • Committee’s guidance note on “Sound practices for the management & supervision of operational risk (Feb, 2003) needs to be consulted for any criteria.

    13. MARKET DISCIPLINE – PILLAR 3

    • Purpose is to complement the minimum capital requirement (Pillar – 1) and the

          Supervisory review process (Pillar – 2)

    • By developing a set of disclosure requirements for markets to assess key elements
    • On the scope of application, capital, risk exposure, risk assessment processes and hence the capital adequacy of the institution
    • Disclosures should be consistent with how the Board or Top management will assess and manage the risks – which will enhance comparability.
    • Market discipline can contribute to a safe & sound banking environment
    • Non-compliance with disclosures would attract a penalty (No additional capital requirement)
    • Only aimed at disclosure of capital adequacy
    • Should not conflict with accounting standards/ requirements
    • All Pillar – 3 disclosures must be at the end of the accounting year
    • Larger banks need to make interim disclosures – say on quarterly basis.
    • Need not be audited by external auditors but bank supervisors have to set in a Validation process
    • Balance need to be achieved in disclosures
    • First set of disclosures by early 2007
    • Pillar – 3 has narrower focus

    14. Transition
    The Migration to Basel – II needs to be achieved in a non- disruptive manner
     
    15. Basel – II  :  Some Reflections
    Fed Governor Ms Susan S.Bies
    “Basel II should not be seen as an end in itself, but a means to promote broad stability and enhance safety and soundness of financial institutions … . The Accord is another step to minimize the negative consequences of risk taking”

    “ Basel II is intended to mitigate potential disruptions in banking markets by improving risk measurement  and management: establishing a better link between risk and minimum capital ratios: and proving more information to bankers, bank supervisors & market participants.

    Fed Governor Mark W Olson
    “ A fundamental primise of Basel II is that, for the major banks, neither supervisory actions nor market discipline can be effective unless bank’s own systems can be depended on the measure and manage risk – taking and capital adequacy. Basel II is intended to provide both a frame work and incentives for achieving those ends”.


    *  Hindu Business Line, 03-01-2002.

    *  Published in the Opinion Column of the New Indian Express, Feb 2002

    * Banking Ombudsman, Andhra Pradesh, Former Executive Director of RBI and World Bank’s Advisor.

     
         
     

    The New Basel  Accord

    G. Sreekumar

     

    In a Country which looks down upon skyscrapers, the 18-storeyed funnel-shaped office of the Bank for International Settlements (BIS) in Basel, Switzerland, indeed looks tall and majestic.  Basel is on the Swiss border with Germany and France.  Both countries can be seen from the 18th floor lounge of the building, internally referred to as “The Tower”. First-time visitors are told, in a lighter vein, that though they only visited Switzerland, they could tell people back home that they “saw” two other countries as well.

    The BIS plays host to, among other bodies, the secretariat of the Basel Committee on Banking Supervision (BCBS). Marathon deliberations over minute details of regulatory standards and guidelines are usually interspersed with lunches or cocktail dinners in the 18th floor lounge where matters of import to the world of banking regulation are discussed and often finalized.  Thus, the reach and influence of the institution goes far beyond the borders that it over looks.

    The BCBS had its genesis in the failure of the German bank, Bankhaus Herstatt, in 1974, which left behind a telling need to coordinate banking supervision especially among the G-10 countries, which were affected the most by the failure.  The office of the BIS, whose membership was broadly the same as that of the G-10 countries until the mid-1990s, proved an ideal meeting ground to thrash out issues of common interest and lay down minimum standards for banking regulation and supervision.

    The BIS, set up in 1930, is the oldest international financial institution.  It soon grew out of its original mandate of dealing with reparation payments relating to the First World War and came to be increasingly recognized as the principal centre for international central bank cooperation.  Even long before the International Monetary Fund was set up, the bank had, during the crisis of 1931-33, supported the Austrian and German central Banks, thus earning it the epithet of “Central Banks” “Central Bank”.  It perhaps helped that the BIS was conveniently located in Basel, the third largest Swiss city and the “rail junction of Europe”, where North-South and East-West traffic pass through.  Central bankers and bank supervisors from the major European countries could retreat to this idyllic “pocket-sized metropolis” for thrashing out issues of common interest.

    Basel Panel’s Role

    Over the last three decades of its existence, the Basel Committee has made landmark contributions in laying down minimum standards for banking regulation and supervision across the world and in fostering international coordination among bank supervisors. It has also, through what is known as “The Joint Forum”, in association with the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS), the corresponding bodies for coordination among supervisors of the securities and insurance businesses, helped lay down minimum standards for supervision of financial conglomerates which may be involved in these businesses in addition to banking.

     

    The Committee’s efforts have made the city of Basel synonymous with the best practices and standards in banking regulation and supervision.  Perhaps the most far-reaching of these initiatives was the laying down of minimum capital standards in 1988, known as the Basel Capital Accord, to ensure a level playing field in terms of capital required to be maintained by internationally active banks.

    The immediate trigger was provided by the protests over the lower capital requirements in countries like Japan as compared to the stricter norms then prevalent in the U.S and the other countries. Though the Basel Committee has only 13 members, the fact that the capital standards of 1988 were implemented by around 140 countries, though customized to local conditions, points to their near universal acceptance.

    Original Accord
    The original accord, now known as Basel-I, was quite simple and adopted a straight-forward “one size fits all approach”, which does not distinguish between the differing risk profiles and risk management standards across banks.  For instance, no matter whether a bank lends to a blue chip multinational or to an itinerant trader, all advances carried an equal risk-weight of 100 per cent.  Past payment record, availability of good collateral or a favorable credit history in respect of the activity or the region where the borrower operated did not entitle a bank to apply a lower risk-weight.

    The original accord also concentrated on “credit risk” and eschewed any effort to address other significant banking risks such as “market risk”, “operational risk” and “liquidity risk”.  The Accord did not also take into account the covariance between the different types of risks, a deficiency which remains even under the revised Accord.  An amendment was made to the Accord in 1996 to cover capital requirement for “market risk”.

    Efforts had been on for the last six years and more to rectify the deficiencies of the original Accord.  The first version of a revised Accord came out in 1999, followed by two other versions in 2001 and 2003, all of which were put out to invite comments and suggestions for change.  The expectedly generated a great deal of discussion and debate and the official responses of various central banks, supervisors, consultants, rating agencies, and the like, are available on the website of the BIS (www.bis.org).

     

    On June 26, 2004, the committee unveiled a final version, titled the “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” and more popularly known as the New Basel Capital Accord (NBCA) or just Basel – II. During the initial period of debate and consultation. Basel – II was both pilloried and acclaimed alike; but, opinion was undivided that change from the earlier simpler methods of Basel – I was both inevitable and long overdue, and that the revised Accord will change the face of banking worldwide.

    What is Basel - II

    The main feature of Basel – II is that its structure rests on a set of three “mutually reinforcing” pillars, namely, capital requirements, supervisory review and market discipline (Box. 1). Through this approach, Basel-II aims to correct most of the deficiencies that Basel-I suffered from.  To start with, the standards are now more risk-sensitive. In other words, banks which have a larger risk exposure will have to set apart more capital to meet the unexpected losses that go with it.  In addition to the original emphasis on credit risk and the capital charge for market risk introduced in 1996. Basel II has now incorporated a provision for capital to take care of operational risk (the risk of loss on account of inadequate or failed systems, processes and people, and from external events). With this, all the three major banking risks are now covered.

     

     

    The Three  Pillars
    The Capital Framework, under the New Basel Capital Accord, rests on the following three “mutually reinforcing “ pillars:
    Pillar 1:  Minimum capital requirements. Banks will be required to set apart capital for the credit, market and operational risks faced by them. A menu of approaches of increasing sophistication and lesser capital requirement will be available to choose from for each of the three risks.

    Pillar 2: Supervisory Review. This will involve a comprehensive review of the systems to calculate capital under Pillar 1 and also for risks not covered under Pillar 1 to ensure that banks operate with capital more than what is required as a minimum.  The supervisor may, based on the review, adjust the capital requirement upward.

    Pillar 3: Market Discipline.  This is aimed at enhancing market discipline by ensuring that an adequate level of transparency is maintained by banks in their disclosures to the market participants in respect of various critical aspects of their functioning.

     

    Menu Approach

    Under Pillar 1 (Minimum Capital Requirements), the committee has prescribed various approaches for calculation of capital for credit, market and operational risks (Box 2). The
    major innovation, as compared to Basel-I, is the introduction of a menu approach, first made for market risk in 1996.  The menu involves a choice of approaches with increasing complexity and rigour, and corresponding lower levels of capital requirement.  This means that banks, which are more sophisticated and have better data collection mechanisms and risk management systems, could choose to introduce, with the approval of their supervisors, more sophisticated methods for estimation of their capital requirements.  Eligibility to adopt the more advanced approaches will hinge on satisfying the supervisors about the bank’s compliance with a host of stringent qualification criteria. These more sophisticated methods are expected to entail lower capital requirements, thereby giving banks an incentive to adopt better risk management practices.

    In the menu approach, capital for credit risk can be through a standardized approach, based on external assessments of eligible credit rating agencies and an array of differential risk weights calibrated according to the risk profiles of each category of assets.  Alternatively, banks can also choose to have either a “Foundation” or “Advanced” “Internal Ratings Based” (IRB) approach.  But, to be eligible for the IRB approach, banks will have to satisfy their supervisors that they have sound data collection and IT systems, and that their internal models are tested for their integrity and robustness through validation and back-testing techniques.  The requirement for market risk remains, by and large, unchanged from 1996, under which there is a standardized and the more sophisticated models approach to choose from, the latter requiring prior supervisory approval for its use.

    Capital charge for operational risk, which remains perhaps the most controversial of the committee’s proposals, can be based on either of three approaches; the Basic Indicator, Standardized, or the Advanced Measurement approaches, representing a continuum of increasingly sophisticated approaches and decreasing levels of capital requirements.  As in the case of other risk, eligibility for using the more sophisticated methods will depend upon the banks complying with rigorous qualitative and quantitative standards.

    The Basic Indicator Approach is a relatively crude measure which sets the capital requirement for operational risk at 15 per cent of the average of the positive gross incomes for the previous three years.  Under the Standardized Approach, the gross incomes are distributed among eight business lines and the capital worked out based on predetermined factors for each business line. Under the Advanced Measurement Approaches (AMA) banks may make their own internal assessments of capital required to be maintained for operational risk based on internal an external data and modeling techniques the acceptance of which will be subject to prior supervisory approval and validation through back testing.

    Since the measurement of operational risk in banks is a relatively nascent subject still being evolved, the committee has been very cautionary in its approach and, therefore, adds: banks must have and maintain rigorous procedures for operational risk model development and independent model validation. Prior to implementation, the committee will review evolving industry practices regarding credible and consistent estimates of potential operational losses.  It will also review accumulated data, and the level of capital requirements estimated by the AMA, and may refine its proposals if appropriate”.

     

     

     

                                                 
    Supervisory Review

    The provision for capital is only the first of the three “mutually reinforcing” pillars provided for under the New Accord.  “Supervisory Review”, the second pillar, is “intended to not only ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks”.  The supervisory review process will be based on four principles (Box 3) aimed at ensuring compliance, on a continuing basis, with the minimum capital requirements and the stringent qualitative and  quantitative criteria that will enable banks to qualify for the more advanced approaches.

    Through this process, supervisors will assess whether the capital maintained is consistent with the risk profile of the bank and take appropriate and timely remedial steps when the capital is found to be falling below the required standards.  Among other things, this may include an upward revision in the capital to be maintained under Pillar I.  The supervisory process is also expected to capture risks that are either not or not fully captured by Pillar I. namely, credit concentration risks, interest rate risk in the banking book, business and strategic risks, and also the effects of factors external to the bank, such as business cycle effects.

    Pillar 2 – Supervisory Review: Four Principles

    1. Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
    2. Supervisors should review and evaluate banks internal capital adequacy assessments and strategies as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.
    3. Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.
    4. Supervisor should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

     

    Market discipline

    Market discipline is an important element in ensuring that bank behaviour is along desired lines.  This forms the third pillar of the New Accord and complements the first and second pillars.  Banks will be required to disclose, among other things, core and supplementary information on the components of capital, its adequacy and the method of risk assessment and risk management processes.  Such disclosures will enable all stakeholders including depositors to make an informed judgment on the capital adequacy of banks and thus encourage banks to behave prudently thereby promoting overall financial stability.  The Committee is not very prescriptive with regard to the elements of market discipline and the details such as materiality limits and frequency of disclosure which will have to be decided by the banks themselves.  The “baseline” level of disclosures will cover the following: Financial performance, financial position (including different tiers of capital, solvency and liquidity), risk management strategies and practices, risk exposures, accounting policies, and information relating to basic business, management and corporate governance practices.  There are detailed recommendations in this regard in an earlier BCBS paper of 1998, “Enhancing Bank Transparency”.

    Charges of Complexity
    Basel – II has been criticized for becoming more and more complex in its quest for trying to be more and more accurate.  But, then, banking is a complex business, and increasingly so fro the last three decades since the collapse of the Bretton Woods agreement and the consequent shift to floating rates, and the other changes that have swept the world of banking in the form of technology induction, deregulation, globalization, and mergers and acquisitions. Secondly, the risk-sensitive approaches, it is argued, can have procyclical effects that will aggravate the booms and busts and thereby affect the real economy.  This speculation is still at the theoretical level and one will have to wait for implementation to be able to draw firmer conclusions.  The anti-cyclical elements in the proposal, such as that for operational risk, and building excess capital, in times of boom, can alleviate the procyclical effects to a large extent.

     

    The banking sector in the emerging market economies (EME) can face unique problems due to lack of well-developed credit rating systems, data collection mechanisms that are robust, which will entail the adoption of the cruder capital assessment methods and the consequent higher capital levels that will have to be maintained.  This will give rise to intra-national and cross-border implementation issues making such banks uncompetitive vis-à-vis the other domestic and foreign banks operating in their terrain.  Cross-border implementation of the Accord will require appropriate systems for sharing information among supervisors.

    The impact of the first and the second pillars will be a strain on the skills of both bankers and their supervisors, and more so in the EME countries.  Upgrading skills of both bankers and supervisors will be a major challenge.  Appropriate roles for external auditors and consultants may have to be carved out to ensure orderly implementation.  The Basel Committee has set up an Accord Implementation Group to facilitate the changeover and assist various countries in this regard.  The Financial Stability Institute (FSI), Basel, is also taking initiatives to train bank supervisors.

    Implementation Phase

    A survey conducted by the FSI shows that more than 100 countries will be implementing Basel – II in the next few years and that, by 2009, more than 5000 banks controlling 75 per cent of banking assets in 73 non-BCBS jurisdictions will be subject to Basel-II.  As for the BCBS member countries, the U.S has already announced that it will be made mandatory for the ten biggest banking groups which account for nearly 70 per cent of the banking assets.  Other banks are expected to follow suit more by the effect of an implied “moral suasion”.

    The European Union is also expected to implement it for all banking groups.  The IMF and World Bank, recognizing the complexity of the Accord, have already announced that its country-specific financial sector assessments will not take into account implementation of Basel – II as one of the criteria but will focus mainly on compliance with the “Core Principles for Effective Banking Supervision” as laid down by the BCBS. However, most bank supervisors are likely to implement the entire Accord though after customizing the same to local conditions and requirements.

    Just as the original Basel Accord changed bank behaviour, which manifested in a slowing down of lending, moving of assets to off-balance sheet and in the introduction of new sophisticated derivatives, Basel II is also bound to unleash a new wave of changes in how banking is conducted.  The shape of these changes is still in the realm of speculation. However, with the capital requirements loaded in favour of larger banks having better systems and consequent ability to benefit from the lower capital that goes with implementing the more advanced approaches, it can be safely concluded that the world of banking will witness a spate of large scale bank mergers, especially between internationally active banks, in their struggle to remain competitive.  While Basel – I can be said to have aggravated the process of disintermediation to some extent, Basel II may set in a process of “reintermediation” where the better borrowers, thanks to the lower risk weights, will rather go to their bankers rather than access the capital markets for their funding requirements. Basel II is expected to be implemented from January 2007. Many countries are expected to buy more time.

    The level of implementation of the capital standards, like all other standards for banking regulation and supervision, is a matter of concern not just to the respective countries.  This has been underlined, time and again, by banking crises (BBCI and Barings, for example) originating across the world. So, non-implementation or partial implementation, without valid reasons, will finally get reflected in adverse credit ratings, higher borrowing costs and the consequent effects on the real economy.

    Rather than capital per se, the real benefits of Basel II will perhaps lie more in the improvements that will be brought about in the long run through more robust risk management systems and the all round upgradation of skills.  It will be a long wait before the benefits will become more visible, but one which will be worthwhile.


    Basel  II Norms-
    Emerging Market Perspective with Indian Focus

     

    Rupa Rege Nitsure

    At this present juncture, early in the 21st century, India is at an unprecedented moment in its economic growth phase. Since 1993-94, the country has not just managed to restore the higher growth that it had achieved in the decade of 1980s but has shapely reduced the volatility in its GDP growth.1 This is made possible by the steady improvement in Indian economy’s resilience to exogenous shocks in recent years.

    A steady improvement in India’s macroeconomic performance and the strengths of its banking system are not uncorrelated events. Like Germany and Japan, India too has a bank-dominant financial system. Which is highly diversified in its composition. Banks in India have played a leading role in mobilizing savings, allocating capital, overseeing the investment decisions of firms, besides providing risk management vehicles. Indian banking sector today is estimated at about US $ 35 billion (in terms of total banking assets) and has been growing at 15.0 per cent per annum.

    Bank credit has always been a dynamic instrument of growth in India - even post-economic liberalization. The conjecture of ‘disintermediation’ of the banking sector after the growth of capital markets since the early 1990s stands invalidated, as some empirical studies have conclusively shown the complementary roles played by both banks and capital markets in financing the corporate sector’s physical investment in India’s liberalized economy[Mathew Rege-Nitsure and Sabnavis 1999]. The process of providing banking services has, however, changed rapidly from traditional banking in recent years. Today, banks have emerged as a one-step shop of varied financial services and the old institution-specific segmentations have blurred considerably. The rapid pace of technological advancement and internationalization of banking services have opened many new frontiers for banks.

    To fulfil the financial needs of a growing economy like India, banks have been undertaking increasingly complex financial operations) both in credit and trading), which are exposing them to several risks. In recognition of this trend, the Reserve Bank of India (RBI) has been highlighting the importance of improved risk management practices since 1999. In general, the RBI’s stance has always been one of gradual convergence with international best standards with suitable country specific adaptations.

    An attempt is made in this article to illuminate a number of issues related to the New Capital Accord(Basel II) of the Basel Committee that sets out the details for adopting more risk sensitive minimum capital requirements for banks. The article is primarily focused on issues relevant to emerging economies in general, and India in particular.

    Need for Basel II
    Over the past 20 years, there have been several examples of banking crises that have threatened wider systemic damage. Instances of Mexico (1982), the other Latin American debt crises of the 1980s, Mexico again in 1994 and 1995, and then the east Asia’s debt problems of 1997 and 1998, Russia in 1998 and Brazil in 1999 -  are all sad reminders of how banking sector weaknesses can result in huge economic losses involving sometimes massive costs of banking sector restructuring.

    Actually, the Basel Capital Accord (Basel I ) of 1988 was evolved by the Basel Committee2  to prevent major bank failures. It primarily comprised principles for able risk management, capital adequacy, sound supervision and regulation, and transparency of operations. It introduced for the first time an internationally accepted definition of bank capital and prescribed a minimum acceptable level of capital for banks. This framework was progressively introduced not only in member countries but also in the more than 100 other countries that have active global banks.

    The reason for its unquestioned acceptance by advanced as well as less developed countries, lay largely in the fact that it arrived on the scene precisely when many countries were reforming their financial sectors [Nachane 2003]. India was no exception to this.  The Narasimham Committee Reports I and II had heavily relied on Basel I for their entire agenda for the banking sector reforms in India.

    However, the banking industry world over has undergone a major transformation since Basel I was implemented in 1988. Two specific changes – the expanded use of securitization and derivatives in secondary markets and vastly improved risk management systems had significant implications for Basel I. For banks that operate on a global scale in virtually all financial markets, Basel I has become outdated.

    In recognition of these trends, the Basel Committee proposed a new ‘Capital Adequacy’ framework (BeseIII) in June 1999, which recommends more risk-sensitive minimum capital requirements for banking organizations. The new framework was widely debated and discussed by regulators of different countries and debated and discussed by regulators of different countries and members of the banking industry before the Basel Committee endorsed its final document on June 26, 2004. The new framework will be available for implementation as of year-end 2006.  The most advanced approaches to risk measurement will be available for implementation as of year end 2007. The G-10 governors and supervisors have encouraged authorities in other jurisdictions to consider the readiness of their supervisory structures for the Basel II frame work and recommended that they proceed at their own pace, based on their own priorities[BIS 2004].
    How Basel II differs from Basel I

    As stated earlier, advances in risk management practices, technology, and banking markets have made the simple approach of Basel I less meaningful for many organizations. For example, Basel I set capital requirements based on broad classes of exposures and does not distinguish between relative degrees of creditworthiness among individual borrowers.

    According to the BIS Paper (2004), the Basel II frame work is more reflective of the underlying risks in banking and provides stronger incentives for improved risk management. It builds on the basic structure of the Basel I for setting capital requirements and improves the capital framework’s sensitivity to the risks that banks actually face. This is deemed to be achieved in part by aligning capital requirements more closely to the risk of credit loss and by introducing a new capital charge for risk exposures caused  by operational failures.
    To accomplish the goal of adequate capitalization of banks, the Basel II framework has introduced three ‘pillars’ that reinforce each other and enhance the quality of banks’ control processes.

    Under ‘pillar 1’, the Basel II improves capital adequacy for banks by requiring higher levels of capital for high credit-risk borrowers and vice versa. Here, three options are available for banks to choose an appropriate approach for credit risk assessment. Under the’ standardized approach’ to credit risk the relatively less sophisticated banks are supposed to use the ratings given by external credit rating agencies to assess the credit quality of their borrowers for regulatory capital purposes. Banks that possess sophisticated banks are supposed to sue the ratings given by external credit rating agencies to assess the credit quality of their borrowers for regulatory capital purposes. Banks that possess sophisticated risk measurement systems may with the approval of their supervisors, select from one of two ‘internal ratings-based (IRB) approaches (the foundation and advanced models to credit risk. Under these options, banks rely partly on their own measures of borrowers’ credit risk to determine their capital requirements, subject to strict data, validation, and operational requirements. Under the ‘Foundation IRB Approach’ and operational requirements. However, the Advanced IRB Approach’ also lets them supply key variables such as loss given default and other risk measures3 . In addition to the credit and market risk covered by the Besel I framework, Basel II establishes an explicit capital charge for a bank’s exposure to operational risks, ie, the risk of losses caused by failures in systems, processes or staff or that caused by external events, such as natural disasters. Similar to the range of options provided for assessing credit risk exposures, banks will choose one of the three options for measuring operational risks’ exposures. These are - the ‘Basic Indicators Approach that employs a single proxy for the entire bank such as trading volumes, the ‘Business Line Approach’ that uses the committee imposed capital ratios for different business lines (such as retail banking, corporate financial services, payment and settlement, etc) and the ‘Advanced Measurement Approach’ that uses a bank’s own loss date within a supervisory specified framework. ‘Pillar 2’ is represented by the effective supervisory review of “Pillar 1”, whereby bank supervisors are expected to evaluate the activities and risk profiles of individual banks in order to determine whether those banks have provided adequate capital under “Pillar 1’ and suggest ways to set right the discrepancies, if any. ‘Pillar 3’ is represented by the market discipline to ensure prudent management by banks by enhancing the degree of transparency in banks’ public reporting. It sets out the public ‘capitalization’ more transparent. Keeping in mind the growing complexities of banking operations, the Basel II framework covers not just banks but also securities firs, asset managers, insurance companies, etc, with any involvement in banking, fund or asset management, securitization, long-term equity holdings, etc. The qualitative difference between Basel I and Basel II is summarized in Table 1.

    While everybody accepts the significant potential of Basel II framework in improving risk management practices, there are some caveats, especially for its implementation in emerging economies.

    Basel Ii framework was originally designed in the context of internationally active banks in G-10 jurisdictions, which are already largely in compliance with Basel I and the Basel Core Principles (BCP). But Basel II, at the stage may not be the priority objective in “Banking Supervision” for many developing countries with less advanced banking systems. The implementation of Basel II would require both banks and supervisors to invest large resources in upgrading their technology and human resources to meet the minimum standards. This may distract the attention of supervisors from ‘supervision’ to ‘implementation’ issues [Nachane 2003].

    As per the International Monetary Fund’s (IMF) Staff Note on Basel II (2004), there are many serious ‘gaps’ in the baseline compliance of several developing countries with respect to BCP. The baseline compliance reflects a system fully or largely compliant with the BCP, which incorporates Basel I as the capital adequacy standard. In the course of 71 assessments conducted by the IMF as part of its “Financial Sector Assessment Programme’

    Table 1: Basel I Versus Basel II

    Basel I

    Basel II

    1. Focus on single risk measure

    1. More emphasis on bank’s own internal risk management methodologies, supervisory review and market discipline.

    2. One size fits all

    2. Flexibility, menu of approaches, capital incentives for better risk management, granularity in the valuation of assets and type of businesses and in the risk profiles of their systems and operations.

    3. Broad brush structure

    3. More risk sensitivity by business class and asset class, multidimensional , focus on all operational components of a bank

    Source: “The New Basel Capital Accord: An Explanatory Note”, BIS, January 2001 Implications of Basel II for Emerging Economies.


    The author is General Manager, Reserve Bank of India and was a Visiting Fellow with the Basel Committee on Banking Supervision, BIS, Switzerland. His views are personal, Published by courtesy The Hindu Survey of Indian Industry 2005

    From Economic and Political Weekly, March 19th , 2005. Published by courtesy of Editor EPW

     
         
     

    Covering 12 advanced, 15 transition and 44 developing countries the IMF staff has noted many deficiencies in the area of risk management, consolidated supervision, and corrective action for undercapitalized institutions-all of which are crucial for the proper implementation of Basel II. Table 2 aptly reflects the ‘gravity’ of the ‘non-compliance’ problem for developing countries.

    Table 2 reveals that about half the developing countries were assessed as noncompliant by the IMF, with BCP 6 dealing with capital regulation, BCP 11 dealing with country risk, BCP 22 dealing with formal powers of supervisors for corrective action and BCP 20 dealing with consolidated supervision. More than BCPs 12 and 13 dealing with market and other risk management, while over one-thirds of developing countries were non-compliant with BCPs 12 and 13 dealing with market and other risk management, while over one-third did not comply with BCP 8 dealing with loan evaluation and provisioning, and BCP 21 dealing with accounting and information requirements. This critically brings across ‘developed’ and ‘developing’ countries within the specified period of time.

    Another major argument pertaining to the effect of Basel II on emerging economic relates to the adoption of IRB system under Basel II. The adoption of IRB system is not just costly but also discriminates against smaller banks. There is also a possibility of heightened cyclicality of global bank credit under this system. In brief, the ideas runs like this. In a business down turn, a banks’ capital base is likely to be eroded by loan losses. As a result of this, its existing non-defaulted borrowers will also be downgraded by the relevant credit risk models, forcing the bank to hold more capital against its current loan portfolio. To the extent that it is difficult for the bank to raise fresh external capital in bad times, it will be forced to cut back on its lending activity, thereby contributing to the worsening of the initial downturn. Thus, Basel II is likely to exacerbate cyclical fluctuations- a price too high for emerging economies once they adopt the advanced IRB system.

    Recent empirical research [Stephany Griffth-Jones et al 2004] show that Basel II would quite significantly overestimate the risk of international bank lending to developing countries, leading to a sharp rise in the cost of bank borrowings by these countries as well as a fall in their capital inflows. This is likely to damage the growth potential of emerging economies. There is also a growing concern that Basel II norms may go against the interest of small enterprises, infrastructure projects, etc, which require a more liberal approach to bank credit. It is feared that adoption of elaborate and cumbersome regulations such as Basel II may adversely affected the risk appetite of banks in developing countries and attainment of ‘sound banking’ could be at the cost of growth.

    In the initial years of implementation, internationally active banks of developed world are likely to adopt the IRB approach for risk management and hence will be more dependent on standardized approach to begin with and hence will not be highly tries will be more inclined to assume exposures to high risk clients. This is likely to increase the ‘vulnerability’ of banks in the less developed countries to economic downturns.

    Thus, instead of creating a level playing field between banks of different financial strengths, the Basel II framework will introduce more unevenness in certain respects. 

    Indian Case
    a) Stable banking system: In terms of overall performance of its banking system. India at the middle position compared to other countries from the middle –income and low-income groups (Table 3)
    Moreover, the overall size of the Indian banking sector is not very large implying a lower vulnerability of India’s real sector to banking failures. For instance, the ‘Banks Assets/’GDP’ ratio stands at 47.55 per cent for India, as against its level at 97.70 per cent for Korea, 166.07 per cent for Malaysia, 90.78 percent for Philippines, 116.85 per cent for Thailand, etc. However, in India a very high percentage of bank assets are owned by the government (around 80 per cent) implying a tight regulation of a large segment of banking industry in India.
    b) Proactive approach to prudential regulation: India is much ahead of several other developing countries in instituting prudential norms for its banking industry.
    While the minimum capital adequacy requirement under the Basel standard is 8 per cent, the RBI has stipulated and achieved a minimum capital of 9 per cent. Banks in India are currently in the process of implementing capital charge for market risk prescribed in Basel II. But since 1998, the RBI has in place several surrogates such as Investment Fluctuation Reserve of 5 percent of the investment portfolio, both in the ‘Available for Sale’ (AFS) and ‘Held for Trading’ (HFT) categories plus a 2.5 per cent risk weight on the entire investment portfolio-whereas Basel norms take into account only the trading portfolio.
    India is one of the early countries, which subjected itself voluntarily to the Financial Sector Assessment Programme (FSAP)

    Table 2: Non- Compliance with Core Principles Relevant to Basel II

     

    Non-compliant by Country Grouping
                            (Per Cent)

    Basel Core Principle (BCP)

    Developing

    Transition

    Advanced

    BCP 6-Capital adequacy

    48

    27

    8

    BCP 8-Loan evaluation and provisioning

    39

    27

    25

    BCP 11-Country risk

    55

    60

    25

    BCP 12-Market risk

    66

    53

    0

    BCP 13-Comprehensive/ other risk mgmt

    66

    53

    0

    BCP 20-Consolidated supervision

    57

    67

    0

    BCP 21 –Information/ accounting requirements

    36

    40

    0

    BCP 22-Remidial powers

    52

    33

    17

    Note: * - Assessed as non-compliant.
    Source: IMF Staff Note on Basel II: Guidance for Fund Staff, April 23, 2004

    Table 3: Performance of Banking Systems: A comparison

    Country

    Return on Assets (%)

    Return on Equity (%)

    Non-interest Revenue/Total Revenue (%)

    Non-performing Loans as Per Cent of Total Loans

    Argentina

    0.30

    1.80

    30.70

    8.10

    Brazil

    1.60

    17.50

    0.00

    9.10

    Chile

    0.73

    9.37

    41.62

    1.67

    Malaysia

    1.36

    17.75

    14.97

    10.44

    Philippines

    0.47

    3.74

    17.12

    13.04

    India

    0.47

    9.17

    12.72

    14.70

    Thailand

    -5.30

    -88.62

    13.82

    38.52

    Indonesia

    -6.10

    -110.80

    68.10

    32.90

    Japan

    0.62

    12.97

    38.00

    6.40

    Korea

    1.42

    23.13

    27.50

    13.60

    Singapore

    1.20

    10.50

    Not available

    9.10

     

     

     

     

     

    Source: J Barth, G. Caprio, DE Nolle, Office of the Controller of the Currency, January 2004.

    Of the IMF and its banking system was assessed to be in high compliance with the relevant principles. RBI’s association with the Basel committee dates back to 1997 as India was among the 16 non member countries that were consulted in the drafting of BCP, RBI has been actively participating in the deliberations on the accord and had the privilege to lead a group of six major non G-10 supervisors, which presented a proposal on simplified approach for Basel II to the committee.

    In April 2003, the RBI formally accepted in principle the new capital accord-Basel II. In its annual policy statement in May 2004, the RBI advised banks to examine in depth the options available under Basel II and draw a road mad by end December 2004 for migration to Basel II. It has been decided to review the progress made thereof at quarterly intervals. To begin with, all banks in India will adopt the ‘Standardized Approach’ to operational risk. As stated earlier, the ‘Basic Indicators Approach’ utilizes one indicator of operational risk for a bank’s total activity. Under this approach the Basel committee recommends computation of operational risk as per cent of the average of three years’ positive gross annual income. After adequate skills are developed both at the bank and supervisory levels, some banks may be allowed to migrate IRB Approach. The RBI has already introduced ‘Risk-based Supervision’ in 23 banks on a pilot basis [K j Udeshi 2004].

    c) Challenges ahead for India: As is the case with other developing countries. Basel II has posed enormous challenges for the Indian banking and regulatory system. There have been active efforts in diagnosing the adequacy of our present system and RBI has been playing a lead role in training its personnel in new supervisory practices. It has been issuing policy guidance to banks in terms of building credit information, data polling, and information technology, IT systems. The magnitude of this task is daunting given the fact that in India we have as many as 100 banks and we have to complete the task by December 2006. The major issue for Indian banks is relating to the aligning and upgrading data in existing IT systems for consistency and integrity across the organization. Given the magnitude of investment involved in this effort, banks must focus on the ultimate approaches for credit and operational risk respectively. Basel II’s Advanced Measurement Approach’ (AMA) for operational risk requires banks to develop their own methodologies to minimize the amount of capital that needs to be set aside. Scorecards that comprise forward looking indicators based on answered questions as diverse as fraud, business continuity, staff absence, etc, are increasingly a preferred method for AMA. IT architecture, therefore, has to be designed in such a way that it would provide suitable reporting facilities and facilitate internal credit risk ratings and scorecards for operational risk measurement.

    Furthermore, banks need to undertake massive investments in upgrading risk management skills of their staff covering both quantitative and managerial skills. Basel II is set to influence all areas ranging from business process/systems to organizational structure/strategies. As such, banks will have to establish enterprise wide risk management methodology, a senior management audit and overview process, data collection, IT systems disclosure processes, etc all of which are underpinned by the overall integration of risk into core business process (See Bardoloi 2003).

    Basel II also warrants another major change in the organizational structure of banks. In today’s context, risk reporting is a major hurdle in many Indian banks. To facilitate effective implementation of Basel II, the risk managers in out banks need to be empowered and entrusted with the responsibility to short circuit the system before a problem crops up. To facilitate this, risk managers must have a higher profile and more visibility within banks. This to some extent, may happen automatically, as with the implementation of Basel II the competition will shift to high risk versus low risk banks instead of the present big versus small banks. Still, the top managements of Indian banks have to consciously ensure this change.

    From the regulatory point of view also, there are going to be profound challenges. With 2006 approaching, there will probably be increased ‘mergers and acquisitions’ activity in the banking industry as the new regulatory landscape raises the stat3s for ‘economic of scale’. Thus, there will be new round of consolidation. The acquiring institution will certainly have a regulatory capital benefit. But the creation of new large financial conglomerates would also pose a systemic frisk and the ‘supervisor’ will have to address this competently.

    There will be some problems specific to foreign banks operating in India. In India, foreign banks are statutorily required to maintain local capital and this gives rise to the following issues –whether the internal models approved by their head offices and home country supervisors and adopted by their Indian branches need to be validated again by the RBI, whether these banks should maintain distinct data histories for their Indian operations, whether capital for operational risk should be maintained separately for the Indian branches of these banks, whether these banks can be mandated to maintain capital as per standardized/basic indicators’ approach in India irrespective of the approach adopted by their head office, etc. These issues will have to be resolved by the RBI.

    The RBI will have to see whether too much regulation will stifle the growth of banks credit-especially to sectors like agriculture, SMEs and infrastructure. As recommended by the Basel Committee, we need to adopt the new framework at out own pace, dictated by our own developmental priorities. Currently, India has three established rating agencies in which leading international credit rating agencies are stakeholders and they also provide technical support. However, the level of rating penetration is not very high and ratings are restricted to issues rather than issuers. So, eventually our system will have to move to ratings of issuers and encouraging this will be a big challenge for the regulators of financial sector.

    Conclusion
    The common objective of all supervisors is to maintain a strong and vibrant financial system and to achieve this, it is necessary that banks, banking supervisors and other market participants become more discriminating in their approaches to risks and better equipped to anticipate problems before they turn into crises [Fischer 2002]. As Basel II precisely tries to achieve this, it is perceived as a logical and appropriate successor to Basel I.

    India represents a special case among emerging economies. As a result of economic liberalization that was set into motion in 1991-92, the country has restored the higher growth momentum of the decade of 1980s since the year 1993-94, and managed to reduce sharply the volatility in its GDP growth. Its banking system is stable and has been assessed to be in high compliance with the relevant core principles by the FSAP of the IMF. The RBI’s approach to prudential regulation has always been one of gradual convergence with international standards with suitable country specific adaptations. During the 1990s, when there were too many occurrences of banking crises in emerging economies, the Indian banking system displayed ample resilience to exogenous shocks.

    As regards the implementation of Basel II framework, the question before India is not ’whether to implement’ but ‘how and when’. The RBI has actively participated in the deliberations on the Basel II accord and had the privilege of leading a group of six major non G-10 supervisors, which presented a proposal on a simplified approach for Basel II.

    The RBI has accepted in principle the New Capital accord (Basel II) in April 2003. To begin with, banks in India will adopt standardized approach for credit risk and basic indicators approach for operational risk. But eventually the system as a whole (banks and the supervisor) will migrate to the IRB approach. the task is intimidating given the fact that 100 Indian banks will have to move to the new system by December 2006. the preparation at the bank level is being influenced by a number of factors such as the state of existing data. IT architecture and risk management systems, degree of pressure exerted by the RBI, competitor banks’ actions, and the possibilities of  ‘mergers and acquisitions’ within the system.

    The RBI is trying to resolve a number of regulatory issues keeping in mind developmental priorities (especially issues like adequacy of credit flows to critical sectors like agriculture, SMEs and infrastructure), readiness of the system in terms of the legal and regulatory framework  (efficacy of Securitization Act, etc) accounting standards (domestic versus US GAAP), soundness of corporate governance (especially in a context of recent episodes of bank failures), market discipline and most importantly, a competitive or level playing field issues among banks of different strengths.

    Given the monolithic scale of the task involved, it will be best for the RBI and the banks to move at a measured pace- to commit to a time table that is appropriate given our specific set of circumstances. However, at the bank level, the entire effort should be directed towards the ultimate goal of achieving the advanced IRB and advanced measurement approaches to credit and operational risks. The ‘standardized approach’ has to be treated as the transitional solution, otherwise the ‘risk-sensitivity’ aspect for our banks will be affected if migration to IRB is not achieved at the earliest.

    Instead of looking at Basel II as a G-10 initiative or a global initiative, we should look upon it as the great opportunity to keep our house in order. It is necessary framework to improve the stability and resilience of India’s rapidly evolving banking industry, which is currently placed at a critical phase in its growth cycle. However, it is unfortunate that current Basel proposals do not explicitly incorporate the mutual benefits of lending by advanced countries to developing countries (international diversification). There is also a fear that too much regulation under Basel II adversely affect the risk appetite of our banks and their lending to credit starved sectors. It will be a major challenge for the RBI to maintain healthy credit momentum amid this tighter risk-sensitive framework.

    Our policy-makers, therefore, need to negotiate strongly for the interests of emerging economies in every possible international forum on regulation. We cannot afford to forget the basic fact that Basel II can be effectively implemented only if our economy and markets have strong fundamentals.

    Notes

    [An earlier version of the paper was contributed to Bankers’ Conference 2004 (November 10 and 11), New Delhi. The views Expressed in this article are the authors’ personal views. The author would like to thank Mathew Joseph, economic advisor, Bearing Points Global Operations Inc, Dehradun for his immensely valuable comments on an earlier draft of the paper]

    1. An in-depth analysis of this aspect of India’s economic performance is available in Vijay Kelkar’s lecture-‘India: on the Growth Turnpike’ at K R Narayanan Oration, Australian National University,  Canberra, April 2004.

    2. The Basel Committee consists of officials of central banks of the industrialized G-10 countries and it was formed to evolve a set of core principles of sound banking based on the prevalent international best practices. The G-10 countries include Switzerland, US, UK, Japan, France, Germany, Sweden, Belgium, Canada, Italy, Spain, Luxemburg and the Netherlands.
    3. The probability of  default is defined as the likelihood that a customer would go into ‘default’ within the next 12 months. Exposure at default implies the expected amount of exposure at the point of ‘default’. Loss given defaults is the likely financial loss associated with the ‘default’, net of collections, recovery costs and realized security.

    References.

    Bardoloi, S (2003): ‘Basel II: New Wine in an old Bottle’, Data Monitoring Review, US, September 12’.

    Barth, J.G Caprio, D. Nolle (2004):’Comparative International Characteristics of Banking’, Economic and Policy Analysis Working Paper 2004-1, January.

    BIS (2001): ‘The New Basel Capital Accord: An Explanatory Note’, Bank of International Settlements, January.

    -(2004): ‘International Convergence of Capital Measurement and Capital Standards: A Revised Framework’, Bank of International Settlements, June 26.

    Fischer, S (2002): ‘Basel II: Risk Management and Implications for Banking in Emerging Market Countries’, prepared as the William Taylor Memorial Lecture at the International Conference of Banking Supervisors, Cape Town, September 19.

    Griffith-Jones, Stephany (2002): ‘Mistakes in Basel Accord Could Harm Developing Countries’, IDS News, Institute of Development Studies University of Sussex, UK.

    Griffith-Jones, Stephany, M. Segoviano, S Spratt (2004): ‘Basel II and Developing Countries:
    Cumulative Evidence on the Potential Impact of International Diversification Effects’, a paper presented at the International Conference ‘The New Basel Accord: Challenges and Opportunities for the Americas’, Mexico, July 12-13

    International Monetary Fund (2004): ‘IMF Staff Note on Basel II: Guidance for Fund Staff’, IMF, April 23.

    Kelkar, V (2004): ‘India: On the Growth Turnpike’, a lecture delivered at K R Narayanan Oration, Australian National University, Canberra.

    Mathew, J. Rupa R, Nitsure and M Sabnavis (1999):’Financing of Indian Firms: Meeting the Needs and Challenges of the 21st Century’ in India: A Financial Sector for the Twenties-First Century, J Hanson and S Kathuria (eds), Oxford University Press, New Delhi.

    MC Donough, W J (2000): ‘Future Challenges for Bankers and Bank Supervisors’, BIS Review, 32.

    Mehts, N (2003): ‘The World According to Basel II’, Financing Engineering News, May/June:

    Nachane, D M (2003): ‘Basel II: Implications for Indian Financial System’, Financial Express, November 24.

    Topping, S (2004): ‘Regulatory Forum on Basel II’ , a presentation made at the Asian Banker Summit, May 6

    Udeshi, K J (2004): ‘Implementation of Basel II-An Indian Perspective’ Address at the World Bank/ IMF/US Federal Reserve Board 4th Annual International Seminar on Policy Challenges for the Financial Sector Basel II, Washington DC, June 2.

    Venugopal, D (2004): ‘Putting Basel II Pillars in Place’, The Hindu Business Line July 16.

     

     

     

       
              

     


    Basel II Accord and its Implications

    Sri. V.Leeladhar

    Managing risk is increasingly becoming the single most important issue for the regulators and financial institutions. These institutions have over the years recognized the cost of ignoring risk. However, growing research and improvements in information technology have improved the measurement and management of risk. It’s but natural therefore, capital adequacy of a bank has become an important benchmark to assess its financial soundness and strength. The idea is that banks should be free to engage in their asset-liability management as long as they are backed by a level of capital sufficient to cushion their potential losses. In other words, capital requirement should be determined by the risk profile of a bank.

    The initial capital accord of 1988 was hugely successful with more than 100 countries accepting it as a benchmark. One of the major reasons for the success of this framework was its being simple. It brought in uniformity and attempted to make regulatory capital requirement consistent with the economic capital. Reserve Bank of India introduced risk assets ratio system as a capital adequacy measure in 1992, in line with the Basel accord of 1988, which takes into account the risk element in various types of funded balance sheet items as well as non-funded off balance sheet exposures. In fact, RBI norms on capital adequacy at 9% are more stringent than Basel Committee stipulation of 8%.

    Shortcomings in the present accord
     
    However, the present accord has been criticized as being inflexible due to its focus on primarily credit risk and treating all types of borrowers under one risk category regardless of credit worthiness. The major criticism against the existing accord stems from its

    • Broad brush approach – irrespective of quality of counter party or credit
    • Encouraging regulatory arbitrage by cherry picking
    • Lack of incentives for credit risk mitigation techniques
    • Not covering operational risk

    As time passed, some of the major international banks began using sophisticated models to measure risk. This was when a need was felt to upgrade the Basel
    framework. Therefore, the Basel Committee on Banking Supervision thought it desirable that the present accord is replaced by a more risk-sensitive framework.

    Three pillars

    The new Basel Accord has its foundation on three mutually reinforcing pillars that allow banks and bank supervisors to evaluate properly the various risks that banks face and realign regulatory capital more closely with underlying risks. The first pillar is compatible with the credit risk, market risk and operational risk. The regulatory capital will be focused on these three risks. The second pillar gives the bank responsibility to exercise the best ways to manage the risk specific to that bank. Concurrently, it also casts responsibility on the supervisors to review and validate banks’ risk measurement models. The third pillar on market discipline is used to leverage the influence that other market players can bring. This is aimed at improving the transparency in banks and improve reporting.

     

    Issues and Challenges
    Having given you a brief overview of the current and proposed new framework, I shall now move on to the implementation challenges for the banks especially in a developing country like India. Here, I would skip the methodological details and technical nitty-gritty associated with the new accord, and concentrate instead on more profound implications for the banking industry. While there is no second opinion regarding the purpose, necessity and usefulness of the proposed new accord - the techniques and methods suggested in the consultative document would pose considerable implementational challenges for the banks especially in a developing country like India.
               
    Capital Requirement:  The new norms will almost invariably increase capital requirement in all banks across the board. Although capital requirement for credit risk may go down due to adoption of more risk sensitive models - such advantage will be more than offset by additional capital charge for operational risk and increased capital requirement for market risk. This partly explains the current trend of consolidation in the banking industry.

    Profitability:  Competition among banks for highly rated corporates needing lower amount of capital may exert pressure on already thinning interest spread. Further, huge implementation cost may also impact profitability for smaller banks.

    Risk Management Architecture:  The new standards are an amalgam of international best practices and call for introduction of advanced risk management system with wider application throughout the organization. It would be a daunting task to create the required level of technological architecture and human skill across the institution.

    Rating Requirement:  Although there are a few credit rating agencies in India, the level of rating penetration is very low. A study revealed that in 1999, out of 9640 borrowers enjoying fund-based working capital facilities from banks, only 300 were rated by major agencies. Further, rating is a lagging indicator of the credit risk and the agencies have poor track record in this respect. There is a possibility of rating blackmail through unsolicited rating. Moreover rating in India is restricted to issues and not issuers. Encouraging rating of issuers would be a challenge.

    Choice of Alternative Approaches:  The new framework provides for alternative approaches for computation of capital requirement of various risks. However, competitive advantage of IRB approach may lead to domination of this approach among big banks. Banks adopting IRB approach will be more sensitive than those adopting standardized approach. This may result in high-risk assets flowing to banks on standardized approach, as they would require lesser capital for these assets than banks on IRB approach. Hence, the system as a whole may maintain lower capital than warranted and become more vulnerable. It is to be considered whether in our quest for perfect standards, we have lost the only universally accepted standard.

    Absence of Historical Database: Computation of probability of default, loss given default, migration mapping and supervisory validation require creation of historical database, which is a time consuming process and may require initial support from the supervisor.

    Incentive to Remain Unrated:  In case of unrated sovereigns, banks and corporates, the prescribed risk weight is 100%, whereas in case of those entities with lowest ratting, the risk weight is 150%. This may create incentive for the category of counterparties, which anticipate lower rating to remain unrated.

    Supervisory Framework:  Implementation of Basel II norms will prove a challenging task for the bank supervisors as well. Given the paucity of supervisory resources, there is a need to reorient the resource deployment strategy. Supervisory cadre has to be properly trained for understanding of critical issues for risk profiling of supervised entities and validating and guiding development of complex IRB models.
    Corporate Governance Issues:  Basel II proposals underscore the interaction between sound risk management practices and corporate good governance. The bank's board of directors has the responsibility for setting the basic tolerance levels for various types of risk. It should also ensure that management establishes a framework for assessing the risks, develop a system to relate risk to the bank's capital levels and establish a method for monitoring compliance with internal policies.

    National Discretion:  Basel II norms set out a number of areas where national supervisor will need to determine the specific definitions, approaches or thresholds that they wish to adopt in implementing the proposals. The criteria used by supervisors in making these determinations should draw upon domestic market practice and experience and be consistent with the objectives of Basel II norms.

    Disclosure Regime:  Pillar 3 purports to enforce market discipline through stricter disclosure requirement. While admitting that such disclosure may be useful for supervisory authorities and rating agencies, the expertise and ability of the general public to comprehend and interpret disclosed information is open to question. Moreover, too much disclosure may cause information overload and may even damage financial position of bank.

    Disadvantage for Smaller Banks:  The new framework is very complex and difficult to understand. It calls for revamping the entire management information system and allocation of substantial resources. Therefore, it may be out of reach for many smaller banks. As Moody's Investors Services puts it, "It is unlikely that these banks will have the financial resources, intellectual capital, skills and large scale commitment that larger competitors have to build sophisticated systems to allocate regulatory capital optimally for both credit and operational risks."

    Discriminatory against Developing Countries:  Developing countries have high concentration of lower rated borrowers. The calibration of IRB has lesser incentives to lend to such borrowers. This, along with withdrawal of uniform risk weight of 0% on sovereign claims may result in overall reduction in lending by internationally active banks in developing countries and increase their cost of borrowing.

    External and Internal Auditors:  The working Group set up by the Basel Committee to look into implementational issues observed that supervisors may wish to involve third parties, such a external auditors, internal auditors and consultants to assist them in carrying out some of the duties under Basel II. The precondition is that there should be a suitably developed national accounting and auditing standards and framework, which are in line with the best international practices. A minimum qualifying criteria for firms should be those that have a dedicated financial services or banking division that is properly researched and have proven ability to respond to training and upgrades required of its own staff to complete the tasks adequately. With the implementation of the new framework, internal auditors may become increasingly involved in various processes, including validation and of the accuracy of the data inputs, review of activities performed by credit functions and assessment of a bank's capital assessment process.

     

    CONCLUSION

    Implementation of Basel II has been described as a long journey rather than a destination by itself. Undoubtedly, it would require commitment of substantial capital and human resources on the part of both banks and the supervisors. RBI has decided to follow a consultative process while implementing Basel II norms and move in a gradual, sequential and co-coordinated manner. For this purpose, dialogue has already been initiated with the stakeholders. A steering committee comprising representatives of banks and different supervisory and regulatory departments is taking stock of all issues relating to its implementation. As envisaged by the Basel Committee, the accounting profession too, will make a positive contribution in this respect to make Indian banking system stronger.


    An Edited Version of the speech delivered by V. Leeladhar, Deputy Governor, Reserve Bank of India at the Bankers’ Club, Mangalore on March 11, 2005 published in RBI Bulletin April 2005

     
         
     

    A Media View
    BUSINESS STANDARD
    12th May, 2005
    Waking up to Basel II

    The implementation of the Basel II norms is a key challenge facing the banking sector today.  It raises several issues.  One worry is the prospect of higher capital allocation on account operational risks, estimated to be 12-15 per cent of gross interest income when the Base II norms take effect in India from 2007-08.  It is expected that these operational risk norms would shave at least 2 percentage points off a bank’s current capital adequacy ratio.  Another percentage point or so would be lost on account of the capital to be set aside for market risk.  In short, banks would require much more capital.  That is not too much of a hurdle, since many banks have already approached the capital market to raise funds in order to be Basel II compliant.  Of greater concern are some of the other issues.
    One of them lies in the fact that the better banks would bag the best customers, which would bag the best customers, which would enable them to lower their capital requirements because of the higher credit quality of these customers, leaving the weaker banks not only with second-rung customers, but also the prospect of having to set aside more capital for them. But while this could increase the gap between the stronger and weaker banks, it will provide an incentive for the weak banks to merge with stronger ones; consolidation may result, strengthening the system as a whole.  Next, competition among banks for the best credits (which require less capital) will increase, thinning interest spreads and affecting profitability.  Further, given the prospect of having to set aside much higher capital for the lower rated borrowers, it’s possible that the flow of credit to the smaller companies may be affected.  Smaller banks too will have a difficult time, not only because of their higher capital requirements but also because of the cost of complying with the new rules.  Risks may increase because of the rule that while the capital weighting for unrated entities is 100 per cent, that for the lowest rated is 150 per cent.  And finally, the complexity of the new system is daunting and would require superior information technology and supervisory skills.
    Nevertheless, the intention behind the new norms is to equip the global banking system to deal with the new risks in the system, while at the same time removing some of the anomalies in the older norms.  In fact, Basel II can be seen as part and parcel of the modernization of the Indian banking system, and implementing it will help Indian banks stand up to global competition.  The doubts occasionally expressed about the need for such s stringent standard in Indian banking are therefore misplaced – if Indian banks want to be competitive abroad, if they want to hold their own against the unrestricted foreign competition that will be a fact of life four years from now, then being Basel II compliant will be a big help.  At the same time, it needs to be understood that the Indian market lacks some of the hedging instruments that enable banks to take full advantage of the new norms.  Together with introducing Basel II norms, therefore, the Reserve Bank of India must also develop the market for new products and the tools to deal with risk in the debt market.


     

     
 
 
 
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