MONEY SUPPLY

Money supply can be defined as the aggregate supply of money in circulation, which comprises of currency with the public and demand deposits with the banks. It is the liquid assets held by individuals and banks. Some economists consider time and savings deposits to be part of the money supply because such deposits can be managed by governmental action and are involved in aggregate economic activity. These deposits are nearly as liquid as currency and demand deposits. Other economists believe that deposits in mutual savings banks, savings and loan associations, and credit unions should be counted as part of the money supply. Money supply is also known as money stock or monetary aggregates

There are several measures for the money supply, such as M1, M2, and M3. The money supply is considered an important instrument for controlling inflation .The Reserve bank of India has adopted four concepts of measuring money supply. They are M1, M2, M3, &M4.
The measure of money stock designated by M1 is usually described as the money supply. The components of money supply are currency with the public ie notes in circulation and deposits. It is the narrow measure of money, which is used for everyday expenditure.
Another measure of the money supply is M2, which is the total of M1, savings and small time deposits, overnight repos at commercial banks, and non-institutional money market accounts. M2 is a key economic indicator used to forecast inflation. M2 is also a broad money concept.
M2, plus large time deposits, repos of maturity greater than one day at commercial banks, and institutional money market accounts constitute M3 is also known as broad money concept. This includes net time deposits (fixed deposits), savings deposits with post office savings banks and all the components of M1.

The monetary policy and credit policy addresses the control of money supply. These policies are aimed at increasing or decreasing the money supply. The Reserve Bank of India announces these policies on a half yearly basis, at the commencement of each half-year. The major tools use by the RBI to control the money supply are the bank rate, variation of reserve ratios, open market operation and moral suasion.

When RBI increases or reduces the bank rate, the funds become dearer or cheaper to banks. This either eases the market with more money supply or tightens the market by withdrawing the excess liquidity in the market. The change in the reserve ratios such as Statutory Liquidity Ratio or Cash Reserve Ratio also reduces or increases the funds availability. Statutory Liquidity Ratio represents the investments made by the banks in unencumbered securities approved by the RBI. Under open market operations, the Reserve Bank auctions the treasury bills or buys the bills back so that the excess liquidity in the market would be absorbed. Similarly the buying back of the securities will enable the banks to get funds from the market. The moral suasion is a non-monetary measure. It is psychological pressure applied on the activities of the banks, which ultimately would either withdraw or supply money to the market.

GLOBAL FINANCIAL REGULATORY AUTHORITY- WILL IT BE A SOLUTION FOR FUTURE FINANCIAL CRISIS?

History tells us about the existence of financial system in the world enabling the countries to exchange their currencies. The Bimetallism prevalent prior to 1875 gave way to the Classical Gold Standard. The World War I brought an end to the age old British dominance in the World money management. The Great Depression in 1931 called for a central regulatory system to ensure economic stability in the countries across the world. Thus the move started in 1944 by 44 countries in Brettonwoods in UK brought two Institutions to manage the global financial word. While International Monetary Fund (IMF) was expected to provide assistance to come out of Balance of Payment crisis, the sister institution International Bank for Reconstruction and Development (IBRD), popularly known as World Bank, took the responsibility of extending financial aid to build up ruined economies across the world. The lack of confidence in the British Raj in management of International Monetary System consequent to the failure of the Classical Gold Standard led to replacement of Great Britain by United States on the control. The dominance of US can be witnessed visibly in the Brettonwoods System which had thrust upon the responsibility of conversion of Dollar into Gold at a specified rate which was revised thrice. The failure of US to meet their commitment was the reason fro the failure of Brettonwoods System.

 

The 1922 Geneva Economic Conference provided the platform for giving birth to an International Banking Institution to bring co-operation among the Central Banks across he world. Thus the Bank for International Settlement (BIS) was established in 1931 with its Head Quarters in Geneva to promote central bank co-operation.

 

The Latin American Crisis and the East Asian Currency Crisis in the 1990s were ample evidence for the failure of all the above institutions in managing the International Financial System. If we closely examine the administration of these bodies, we can clearly see the US dominance everywhere. Thus the US has grown to the level of a major economic power capable of deciding the fate of the economies in the world because they are the custodian of the wealth of these economies. Though European Monetary System emerged as an alternate mechanism and Euro was positioned against US Dollars, so long as US Dollar remains as the intervention currency and the foreign exchange reserves of countries are maintained US Dollars, the economic power of US is difficult to be controlled. After dwindling for quite a long time since its inception, Euro is getting stabilized only now.

 

The current financial crisis also was triggered by the US economy. The US subprime crisis was the root cause for the meltdowns of banking institutions and loss of jobs, homes and security for millions in the world. Still they continue to be the custodian of the wealth of economies in the world. Now a new demand has emerged out of the discussion among the world economists for constitution of a Global Financial Regulatory Authority. Prof. Joseph Stiglz while delivering the Lakdwala Speech in New Delhi had put forward this suggestion as a solution to check future meltdowns. At the same time he had criticized the economic policies of US administration and had squarely blamed them for the present crisis.

 

If we examine the role of IMF, World Bank and BIS in preventing a meltdown as that happened in the previous years, we have to accept the fact that these institutions have miserably failed in preventing a crisis. I feel that they were silent spectators of the crashing of markets. The reasons, I feel, could be the US dominance.

 

Now it is not clear what would be the shape of a new regulatory authority. Can the US hands be kept out of this agency? If US dominates this one also will it not be another institution like IMF or World Bank? Being the holder of the major portion of the wealth of nations how can one keep away US from the proposed authority? In my opinion, the countries have to shift their reserve currency from US Dollars to Euro and use Euro as the intervention currency in order to prevent future financial crisis. With weak banking system and lack of control mechanism US can create more havocs in the world financial markets. Unless US is kept out of the scene no new authority can effectively prevent future meltdowns.

GLOBAL FINANCIAL CRISIS AND INDIAN ECONOMY

Financial Crisis is not a new phenomenon in the modern world. The major financial crisis which brought down the economies of Latin American countries such as Brazil, Mexico was the first experience in the modern era. The IMF and US administration lifted these economies through an expensive bail out plan. The second experience was from the East Asian Financial Crisis triggered by the devaluation of Thai Bhat in July 1997. The crisis pulled down eight South East Asian Countries commonly known as Asian Tigers. The countries were Malaysia, Singapore, Hong Kong, Taiwan, Korea, Indonesia, Philippines and Thailand. The melt down drastically brought down not only the stock and currency markets in these countries but the markets in other developing countries such as USA, Japan etc. were also affected on account of the contagious effect. Fortunately Indian economy was spared from a major crash thanks to the conservative approach our administrators had taken with regard to opening up of our economy to the external world as also the insulation mechanism implemented by sterilizing the cash flows from abroad. But the current crisis emanated from the US sub-prime lending became costly to Indian investors as well due to the steep fall of stock prices and weakening of Indian Rupee.

Indian money market was experiencing severe liquidity crunch on account of the heavy FII out flows consequent to the financial crisis abroad. However, we were quick in reacting by initiating appropriate qualitative as well as quantitative measures to arrest the steep fall and rebuild the lost confidence. Reserve Bank of India pumped around Rs.125000 crores to the market in three tranches by reducing the SLR, CRR and Repo rates considerably. The worst affected areas were real estate and SME sectors due to the reluctance of bankers to lend. The RBI initiative enabled the banks to reduce their lending rates by 75 bp and many banks declared lowering their lending rates, especially to home loan sector. The relaxation in the norms for Participatory Notes was another initiative to boost up FII inflows. Another noteworthy initiative was the increase in foreign investments to 49 per cent from the current threshold limit of 26 per cent for investments in insurance sector. On the qualitative side the Finance Minister and Prime Minister assured the country that our banks and markets were safe and the phenomenon was only temporary. Besides RBI on its part assured liquidity to the banking system and certified the safety of Indian Banks. These measures could ease the tension to a great extend and the market started rebounding as witnessed by the upward journey of stock indices and strengthening of Indian Rupee against dollars. The quarterly results of India Inc. also indicate growth potentials.

However, the buoyancy does not last when we look at the employment sector. Globally, the companies have started downsizing consequent to the financial crisis in order to reduce their cost of operations. The Indian counterparts, especially IT companies and BPOs have to follow the path because their business would come down drastically on account of the slow down in overseas economies. The major part of outsourcing is from US and the bad shape of US economy has already spread black shadow on the IT companies. While large companies like Infosys are trying to avoid a huge downsizing, smaller one has no option and hence started retrenchment. The Prime Minister had appealed the industry captains not to retrench their employees consequent to the meltdown; the Indian branches of overseas companies have already started dropping the employees. Recently American Express showed the doors to their employees in India. The loss of employment may create financial and psychological problems to a large population in the country unless they are suitably redeployed.

These events need not melt down our confidence; at the same time we should not be complacent also. The BRIC report has identified India as one of the major economy in the world by 2050. The phenomenon what we now witness is only temporary. The managers of our economy are not simple politicians but they are able and eminent economists and business executives who are capable of envisioning eventualities and initiate timely corrective measures. Though the industrial production has slowed down now, it will rebound in the ensuing financial year. The agriculture production also is showing positive trend and as such the economy will regain its lost momentum with in a short span of time. The inflation is expected to come down to 7 per cent by February next. The crude prices are falling and are expected to touch $55 per barrel. If the trend continues, we may expect a further decline in inflation to 5 per cent by 2010. The employment opportunities will also go up by the above period. The capital market is expected to perform in a better manner because of the lowering of interest on bank deposits and availability of more funds from banks. However, the ensuing election to the Parliament may bring new political equations which can greatly influence the future progress of the country. Let us hope that the economic agenda of the country will not be disturbed by the election process and change of administration.

FINANCIAL EXCLUSION

Financial exclusion can be defined as the process of denying access to financial services to a section of the population. Financial exclusion has become a major concern of many of the countries. A study conducted by Elaine Kempson and Claire Whyley of the Personal Finance Centre, U.K revealed that one and a half million households lack even the most basic financial products and another 4.4 million are on the margins of financial services provision. Various reasons have been assigned for financial exclusion. Some of these reasons are:
Lack of awareness of financial products and services among the households
Lack of sufficient income by the households to save.
Unemployment among the households or underemployment
Young householders who are yet to take decision on availing of financial services
Elderly persons above the age of 70 who depend more on cash
Denial of access to the financial services due to the stringent conditions imposed by agencies providing these services.
Low savings or no savings
Lack of assets
Poor financial habits resulting into indiscriminate spending.
Psychological disabilities
Feeling of being outcast form the mainstream of financial services
Indigenous and ethnical issues
Geographical inconvenience
Lack of time
Computer illiteracy or lack of PC/internet access
Availability of alternate products and services.
Alternate suppliers providing services.

The other phenomena related to financial exclusion are financial illiteracy, financial exploitation and financial discrimination. Financial illiteracy is experienced not only in the rural sector but in some sections of the urban population also, especially among the newly employed youth class. By financial illiteracy we mean the lack of adequate knowledge on of financial services and products, their uses, scope and potentiality. The second phenomena, financial exploitation is the result of either non-availability of organized form of financial services sector or people shy away from the organized sector. There are still people who deposit money in unregistered financial institutions and lose their hard earned savings forever. Another area of concern is the tight grip of loan sharks over the farmers and small businessmen. Many times these people hesitate to go to the organized sector in view of the cumbersome procedures or number of formalities to be observed providing opportunities to unorganized sector to exploit the poor and down trodden. The third one financial discrimination happens when a certain class of customers enjoys privileges when the others are denied of such facilities. whereas in some other cases they proceed with recovery action. In view of these reasons also many times people hesitate to avail of the financial services.

Generally the poor, socially underprivileged, disabled, elderly men, children, women, uneducated, ethnic minorities, unemployed etc. class of people are subjected to financial exclusion.


Financial exclusion imposes significant costs to individuals, their wider neighbourhood and the society at large. Some of the important costs associated with financial exclusion to individuals are higher charges for basic financial transactions and credit, no access to certain products or services, lack of security in holding and storing money, barriers to employment, entrenching exclusion

Financial exclusion brings costs to the society as a whole. Some of the costs to the society are contributor to child poverty, costs to the benefit system, link to social exclusion.

REAL ESTATE FINANCE-IS IT ANOTHER BUBBLE?

The banks have started rethinking about their exposures in real estate. Punjab National Bank has already frozen their loans to real estate. The global melt down in the financial markets consequent to the sub-prime lending fiasco in the US market has sent lightning through the spine of bankers. No doubt the bubble is taking its shape to burst unless further growth is prevented. The lessons from East Asian Countries are good evidences of real estate meltdowns consequent to financial market crisis. It would be interesting to take a journey through the risky territories of this high profile high return credit portfolio of banks.

Traditionally, real estate finance has been a lucrative area not only to commercial bankers but even for the indigenous bankers and village money lenders. During olden days farmers used to mortgage their land with the Zamindars by simply handing over the title deeds and signing a promissory note. The passing of Transfer of Properties Act, 1882 gave a legal frame work for transfer of properties and prevented illegal transfers. The Act extensively covers mortgages, leases and exchanges. Sections 58 to 104 of the Act well explain the legal requirements to make a mortgage effective. Chapters I and II of the act also deal with the requirements to be complied with for making the transfer of properties effective. A bank which extends real estate finance against the security of landed property usually ensures that all these legal requirements are complied with prior to sanctioning the loans. Still the banks run into various risks while financing the real estate sector.

One of the major risks is the legal risk. The legal risk arise out of the non-enforceability of the documents executed by the borrower. This situation may arise due to various reasons such as lack of proper title, non-compliance of legal formalities, inadequate stamp duty, incompetency of the owners to mortgage, restrictive covenants in the document of title to property etc. Banks do exercise vigilance against the legal risk by getting the documents scrutinized by the bank’s legal counsel and further scrutiny by the banks’ own legal officers. Despite all these precautions there are numerous instances where the borrowers could defraud the banks. In some cases even the documents presented happened to be fake which were made with the connivance of the officials of the Registration Department. One of the precautionary measures which banks take is by obtaining non-encumbrance certificate from the Registration Department. If the loan is taken against a registered mortgage, the non-encumbrance certificate will show the details of mortgages. But the mortgage by deposit of title deeds will never appear in the non-encumbrance certificate issued by the registration department. Though the original documents are held by the bank which financed the loan, the borrower manages to get another copy with the help of the officials in the registration department and produce this document before another bank for raising loans. (In Tamil Nadu, a few years ago even the Registrar was a party to such fraud. In Kerala a number of fake Pattayams issued by the revenue officials were confiscated during a raid conduct by the government last year.) When the documents are proven to be fraudulent, the financing bank loses the chance of exercising its right over the property.

Another case of legal risk is certain restrictive covenants in the original document. For example in a Partition Deed, there may be clause preventing the alienation of certain part of the property which is set apart for a specific purpose. But in subsequent documentation this portion may be conveniently omitted without producing the original Partition Deed stating that the original held by another family member and producing a certified copy. The certified copy is provided by the Registration Department and with the connivance of the Department Staff any manipulation could be done. Similarly there could be minor’s right. Section 20 of Transfer of Property Act provides certain benefits to an unborn child which is in the mother’s womb. If the documents are manipulated, the opinion provided by the legal counsel may go wrong. Generally 30 years chain of documents is normally examined by the legal counsel. But in certain cases dilution is permitted by banks, which can turn to be risky on a later date.

Now the major exposures of banks are against builders. The flat culture has given birth to a number of builders who constructs flats and sell to those who are in need. Initially, the constructions were done according to demand. This culture has now been changed to building flats and selling to those who are in need which necessitated extensive marketing of the villas and flats. Many of these firms have tied up with celebrities to market their product by paying hefty sum as remuneration for playing the role as brand ambassadors. There are also firms which sponsors realty shows by offering exorbitant prizes. All these costs are loaded to the flats and villas making them much costly and common man may not be able to afford them. Consequently, the market narrows down and the income generation slows down. On the other hand these groups acquire more land and continue constructions by borrowing from banks and taking advances from prospective buyers. There are many instances where builders vanished from the scene with the money they collected from the prospective buyers, leaving the project half way resulting into default of the loans taken from banks. Often, the whereabouts of these people may not be known as either they cross the boarders of the country or live in anonymity elsewhere. While the large fishes survive the strong current, small fishes quickly vanishes from the scene taking with them the hard-earned money of poor people. Unless banks take urgent measures to prevent the unbridled expansion of building activities at the cost of funds borrowed from them, another bubble may burst soon.

Another class of borrowers who have availed loans for purchasing houses/flats is the employees and salaried class. The boom in the IT and financial sector during the last few years really pushed the earnings of employees to five or six figures. Even fresh graduates from technical institutions and business schools are absorbed by multinationals by offering exorbitant pay and fringe benefits. Take for example the salary offered by the bankrupt investment banker Lehman Brothers to IIM graduates. The reports show that they had offered as high as Rs.18 lakhs per annum. An ISB student was absorbed by another consulting firm by offering more than Rs.1 crore per annum. Now consequent to the meltdown in the financial markets, the MNCs have started downsizing operations. The report shows that HSBC is planning to lay off around 1100 employees. Lehman’s Indian operations have around 2000 employees and all of them have been served with termination letters (www.indianexpress.com, 17.092008). Considering the lay off by Merrill Lynch, Morgan Stanley, Washington Mutual Funds together with that by the IT and ITES firms and BPOs, the number of outgoing employees at different levels would be substantial. A majority of them might have availed of housing loans from banks and financial institutions. Considering the fat pay they were receiving from their previous employers, their exposure in the housing loan may be substantially high. Consequently, they may find it difficult to pay back the funds borrowed, even if a substitute employment is offered to them because in the current market condition no firm can afford to pay such hefty amount as pay and perks. Hence banks have to expect severe repayment problems from this class unless they have already securitized these loans.

The liquidity in the market is highly affected by the meltdowns. Consequently, the disposable funds with investors have come down substantially. The market may experience severe resource crunch and the banks may have to with draw from lending to certain sectors. Many of the realtors have started their expansion process and would now find it difficult to scale down. India’s largest realtor DLF is said to be in the process of raising $750 million through their associate company DLF Asset from JP Morgan. They had loan exposures with DE Shaw and Lehman. DLF may afford this but what about the smaller ones? Many of them will find it continue their building activity since the borrowing cost may go up and it would become uneconomical them to sell the flats/villas at the already agreed prizes. Consequently many of them may leave the scene ending up with losses to the lenders and clients.

Now what can be done the best? Firstly, the banks and financial institutions should persuade the builders to sell the flats as quick as possible. Secondly, instead of stalling the whole construction activities they may finance the building activities in a selective manner. Thirdly, banks may enforce their title at the earliest in the case of properties which are mortgaged to them and where they find that the borrowers have dropped the project. This step will enable the banks to save the interest cost

INDIA'S INFLATION- AN OVERVIEW

Introduction
Inflation can be broadly defined as the rise in price level. Inflation is measured by the movement of price indices. A sustained downward sufficiently long pressure on prices is expected to inevitably bring inflation to an end. ( Kaldor, 1986). Some countries use Consumer Price Index (CPI) as the measure for inflation, whereas some other countries use Wholesale Price Index (WPI). Inflation reduces the purchasing power of people; as a result the prices will go up. The industries may demand for more funds for carrying on the production. Consequently, the demand for funds will go up resulting into the interest rates going up. The opposite of inflation is deflation which occurs when the prices are falling. Inflation will cause unemployment and a rising inflation coupled with a rising unemployment is known as stagflation. USA was facing the problem of stagflation in 1970s (Siglitz & Walsh, 2002). In short, the rate of inflation is the rate of change of the general price level (Samuelson & Nordhas, 2001).

Factors Responsible for Inflation
Inflation can go up or down or even remain at the same rate. Inflation can persist at the same rate for a while and a shock to the economy can push the inflation up or down (Samuelson & Nordhas, 2001). Economists have classified the factors contributing inflation under two major heads. These are Demand Pull Inflation and Cost Pull Inflation.

Demand Pull Inflation: When the aggregate demand overtakes the aggregate output the prices tend to increase leading to inflation. This happens because the fall in the output will weaken the supply side because of which the buyers will be ready to pay any price leading to spiraling prices. For example when the agricultural production comes down the supply of food grains, pulses etc. also come down leading to an increase in the prices of these commodities. The demand pull phenomenon happens when the aggregate money supply in the country goes up which provides enormous money with the people who will be ready to pay what ever the price is asked. The situation leads to the increase in the price. The increase in money supply can happen either at the governmental initiative or industry initiative. The government at times resorts to deficit financing by pumping additional money into economic system by printing currency notes. Since the additional money is not coming from generic sources it can cause price rise. Another factor causing an increase in the money supply is the international capital flows. Unchecked foreign exchange inflows though burgeons the foreign exchange reserve and provides buoyancy, the conversion of these inflows into domestic currency can increase the money supply leading to inflation. In order to insulate the economy from inflationary pressures, countries sterilize these inflows. We have live examples of Latin American and East Asian Currency Crisis when the inflation rates in the affected countries shot up to double digit figures. The demand-pull can also occur on account of wages which increases the supply of money in the hand of people who will be ready to buy goods and services at what ever price they are offered. Consequently the prices of commodities go up causing inflation. Increase in government spending also pushes more money to the market leading to increase in prices.

Cost –Push Inflation: The second factor is the effect of cost. Inflation resulting from rising costs during the periods of high unemployment and slack resource utilization is called the cost-push inflation. For example, during the early 1990s when the Indian economy was opened up, the domestic firms went abroad and borrowed heavily through the External Commercial Borrowing (ECB) route. Consequently, the industry experienced large scale surplus resources, which they invested in the real estate resulting into the real estate in the metros like Mumbai, Delhi etc. shooting up. The cost can also go up when the bargaining power of employees increases and they demand more wages. The manufacturers will load the increase in their cost due to the hike in wages in the products leading to rise in prices. Similarly when the local currency weakens and foreign currency appreciates, the import becomes dearer leading to increase in the cost of inputs which will lead to the increase in prices. On the other hand the increase in the exchange rate will enable the exporters to earn more than their actual investment creating additional money supply in the country again leading to inflationary pressures. Some economists argue that increase is in money supply is the result and not the cause of inflation ( Jennie Hawthorne, 1983).

Another reason is the cost of funds. The interest and inflation rates are directly connected. As inflation rate goes up interest rate also goes up because of the higher price level leads to higher spending necessitating more funds, thereby pushing up the borrowing cost. Another effect of interest is that an upward movement of interest rate will attract more international investments and the consequential capital flow will lead to more money with the people. Unless these inflows are sterilized effectively, the country can be pushed to the grip of inflation.

Management Perspectives of Inflation
The inflation can pose problems for managers from two angles. One is the supply side and the other is the cost side. The inflation increases the prices of raw materials and consequently the managers may be compelled to increase the prices of their products and services. The increase in the price level will push up the cost of production from two angles. One is the raw material prices as explained above and the other is the cost of labour. The employees will demand more wages to meet the increased price level which will push up the labour cost. In fact it becomes a vicious circle as far as a manager is concerned because the increase in wages will push the price of the final output which will lead to demand for further in crease in the wages. From the supply side also this happens because an increase in price will reduce the supply side leading to further reduction in the supply because being unable to bear the increased cost of production, manufacturers may bring down their production. Generally, a conventional profitability statement carries some figures relating to cost such as depreciation charges and cost of goods sold or consumed previous years also. These factors can produce significant errors in profit measurement during a period of inflation (Kirkman, 1978). Therefore, the inflationary pressure often leaves the managers into a dilemma as to whether to increase the cost of their products or to absorb the cost and bear the losses which will eat away their bottomlines. As the managers are accountable to the shareholders, they will often avoid this route. On the other hand managers may be facing the pressure from the government to reduce the cost to contain the inflation. The government may institute several measures like withdrawing the excess liquidity in the market through the Central Bank interventions. Government also may impose levy and quota restrictions in order to curtail the price rise of essential commodities. Managers may also have to face the threat of strike from trade unions if they attempt to wage-cut or refuse to meet their demand for increasing the wages. As a student of management, these situations give me many lessons to learn, particularly the impact of inflation on the economy as well as on the firms.

Inflation in India
The data on inflation in India during the last 5 years covering the period from 1st April 2003 to March 31, 2008 shows cyclical variations in the inflationary pressures. Data collected relates to monthly closing inflation from which quarterly and half yearly averages where computed to study the seasonal and cyclical variations. The following diagrams show the monthly, quarterly and half-yearly variations of the inflation.

Monthly Variations

The chart shows periodical rise and fall in the inflation. The inflation registered 6.7 % in April 2003, but declined to a level of 3.88% by August 2003. During the period September 2003 to February 2004, it was hovering around 5% and then started increasing to reach a peak level of 8.74% in August 2004. The inflation again came down to reach 3.33 % in August 2005 and varied between 4% and 6 % till it registered 6.69% in January 2007. The last figure 6.68% as on 31.03.2008 is very close to that in January 2007. The latest figure shows that the inflation crossed 7 percent and reached 7.33%.

Quarterly Variations

The quarterly average inflation during the period April 2003 to March 2008 varied between 5% and 5% and 6.5% except the peak level of 8.03 in September 2004. Thereafter, the inflation started declining and reached as low as 3.61% in December 2007 and then climbed up to reach 5.3% in March 2008

Impact of Seasonal Variations
In order to check the impact of seasonal variation, a chart was created using the half yearly averages from April 2003 to March 2008. The diagram below shows the half yearly average inflation. In India we have a busy season commencing from October and ending in March and a slack season from April to September. The chart also was constructed using the corresponding data. Reserve Bank of India announces their Annual Policy in April and Mid Term Review in October every year. These policy documents contain measures for arresting inflation. The chart shows that the inflation rates were coming down or going up after the policy announcements indicating some impact on the policy measures on the inflationary trends. During the one year period from April 2003 to March 2004, the inflation came down by more than 1 percent and reached a higher level of 6.9 per cent. Thereafter it gradually declined to reach a lower level of 4.3 per cent and climbed to 5.9 per cent. Towards the last leg the average inflation came down to 4.6 per cent.

Economists are of the view that the inflation in India has primarily emanated from the supply side and mostly from the pressure exerted by the primary articles. The movement of international price of Crude Oil also contributes in pushing up the inflation. A section of the economists are skeptical about the validity of our price indices because of the base year which is 1993-94, the share of different goods in the basket and the time taken to announce the price movements. Another view is that service sector being one of the emerging consumption segments does not have the deserving share in the basket. Alternatively it can be assumed that the inflation in India is more controlled by the prices of Onions and Potatoes and therefore the monsoon and cropping pattern greatly affect the movement of the price indices.

Conclusion

Inflation indicates the changes in price indices at two different point of time. In India inflation is measured by the movement of Wholesale Price Index. Inflation can be demand-pull inflation or cost-push inflation. Our inflation is more or less demand-pull because the supply side play great role in the movement of prices. The inflation affects the industries because of its impact on the cost of production. Hence managers should be concerned about the inflation and do suitable adjustments to contain the inflation.

BUSINESS AND ENVIRONMENT

Introduction
Every organization exists in a country and operates under certain conditions prevailing in the country. The decisions taken in an organization are influenced by various factors, some of them can be internal and some of them can be external. These factors changes according to the passage of time and the changes have various impacts on the achievement of goals by the organization. In other words, the business organizations function in an environment prevailing in the country which has positive or negative impact on the achievement of result by them.

Dimensions of Business Environment
Business environment can be broadly classified into micro environment and macro environment. Micro environment is the environment prevailing in the organization whereas; macro environment refers to that prevailing in the country. It can also be stated as internal environment and external environment. Another classification is market environment and non-market environment. Just like an individual need an environment conducive for growth, the organizations also need environment conducive to grow and produce results. There are various internal and external happenings which can affect the functioning of an organization. While the internal factors can be controllable or uncontrollable, almost all the external factors are uncontrollable. As such the organization should learn to adapt to the external environment so as to ensure its existence.

Business Management and Macro Environment
As already explained macro environment is external to the organization and beyond their control. This can be domestic environment or global environment. An organization which restricts its business to the domestic country only needs to be concerned with the environment with in the country. If the business is expanded to the other countries also, the global environment also can affect the business growth on account of the global market integration. The example for impact of the global environment on the domestic business entities is the recent sub-prime crisis in US Market. The financial conglomerates like City Group had substantial exposures in sub-prime market and the loan default necessitated them to write off millions. Domestic organizations like ICICI Bank also had similar exposures and had to write off claims. Even State Bank of India had such exposures and they allowed their clients to write off the claims. History tells us such stories of economic crashes like the Latin American Crisis and the East Asian Currency Crisis which were lessons to the business entities across the world. The East Asian Currency crisis led to the collapse of many of the Korean conglomerates due to their inability to meet the claims. Natural Calamities like Hurricane Katrina, Tsunami etc. can also affect the existence of business. The Kobe Earthquake brought down the Nikkei Index which resulted into substantial loss to the 200 old Barings Bank, London due to their over exposure to the Index. There are a number of similar examples where the global environment has affected the business growth.

The domestic environment also affects the business growth. The domestic environment can be politico-legal environment, economic environment and socio-cultural environment. The politico-legal environment refers to the governmental approaches to the business. Such approaches represent the government’s policies and decisions which affect the business favourably or adversely. The politico-legal environment has a number of critical elements such as the form of government, ideology of the ruling party, strength of opposition, role and responsibility of the bureaucracy, political stability, velocity of the government policies and programmes, socio-economic legislations and politico-legal institutions.

The form of government can be a capitalistic form, socialistic form or laissez fare economy. The government can also follow autocracy as in the case of communist countries or democracy as in the case of countries like India. The governments are formed by political parties and the ideology of the political parties leads the government’s policies and plans. If the political party ruling a country is committed against corruption, the business firms will be able to get permissions from the governments easily. For example, in West Bengal, the ruling communist party follows the ideology of industrialization of the state as a result, many industrial units are coming up in the state providing large scale employment to the people in that state. On the other hand the government in Kerala, which is also led by the communist party, nurtures a pro-labour policy; as such the industrialists are less interested to invest in this state. During the last month Kerala lost tons of paddy due to the opposition by the farm workers union led by the communist party against use of machine for harvesting the crop and government’s in action against this attitude. As a result the state had to beg to other states for paddy to feed its masses. If the opposition party is strong they can correct many of the wrong decisions of the government. However, as in the case of Kerala where the opposition is weak, their interferences did not produce much results. Because of this many of the decisions taken by the state government are affecting the business units adversely.

Though the government is led by political parties, the administration is in the hands of bureaucrats. The governmental decisions are implemented by the bureaucracy. In a country where the government controls and regulates the business operations, efficiency of the bureaucracy is very important to ensure timely implementation of decisions. Many of the companies have appointed retired bureaucrats as their liaison officers in order to interact with the government machinery and get things done speedily.

Political stability is another factor which affects the business growth. When the ruling party has the absolute majority, they can continue in the government till the end of the term. On the other hand in the coalition government, any of the constituent parties can pull the government down by withdrawing its support. Therefore, the government may have to dance to the tune of these parties. Unstable government may hesitate to take firm decisions which affect the business units. The decisions will be mostly for pleasing the constituents rather than on economic considerations.
The government may formulate policies with tremendous speed, but when it comes to the implementation part, the process becomes at snail’s pace. For example, in Kerala, we started hearing about Metro Rail Project in Kochi for the last so many years. Though the agreement was also signed by the Metro Rail Corporation for implementation of the programme, the process is now at snail’s pace due to opposition from traders. Similarly, though the government started taking back all the government land from the private owners for expansion of the M.G.Road, Ernakulam and demolished the unauthorized constructions, the project is now in dead-lock. Though policies and projects are formulated speedily, the implementation becomes very slow.

The policies of the government are often enforced through various legal enactments. The socio-economic legislations which govern the business operations constitute the legal environment. The legal enactments which affect the business operations in India are Monopoly and Restrictive Trade Practices Act (replaced as Competition Act), Foreign Exchange Management Act, Industrial Disputes Act, Factories Act etc. Lastly, the functioning of the legislative, executive and judicial actions of the government also affects the business environment. For example, the performance of banks will be affected if the loans are not recovered timely and timely decisions on recovery suits filed by banks affects the recovery performance. Similarly, red tapism affects the functioning of the executive machinery; as a result the decisions on many matters of importance to the industry might be getting delayed.

The economic environment can be macro environment and micro environment. Macro environment is country specific and changes form country to country. These include the operation of economic factors like GDP, National Income, inflation, demand and supply, government’s monetary and economic policies etc. The managers have to interact with the economic environments frequently in order to assess the impact of the variations in these factors on the business performance. For example, a government policy on imposing levy for sugar will affect the sugar manufacturing companies. Similarly during the last six months, the software companies in India are incurring losses on account of appreciating Indian Rupee. The changes in the economic factors affect the purchasing power of the people and therefore influence the demand for products. The micro environment is the organization specific and internal factors. These include a fire in the factory or delay in getting working capital finance from bank etc. An example of micro environment is the closure of Perumbavur based Travancore Rayons Ltd. due to the power shortage and trade union militancy.

Lastly, the socio-cultural environment also plays an important role in the success of any business activity. The business should maintain harmony with the social environment. The critical elements in sociological environment of business are social institutions and systems, social values and attitudes, education and culture, role and responsibility of the government, social groups and movements, socio-economic order and social problems and prospects. Social institutions and systems refer to the social systems like cast, creed, child marriage, joint family etc. The changing social values and attitudes like the change of role of women from house wife to working executives or entrepreneurs also have impact on the business growth. Education and culture is the other factor which influence the business. Growing number of business schools imparting business education, Kerala becoming the 100 percent literate state etc. are examples of changes in the education and culture. The government has a pivotal. The government should be committed to reduce social tension and provide atmosphere conducive for the growth of business. Example for the government’s role is the declaration of special economic zones for promotion of exports, establishment of technological park for development of software industry etc. The development of social movements like communism, trade unionism etc. also affects the business growth. The Kerala State is the best example for such social movements. The communism and trade unionism is adversely affecting the growth of business and industry in this state. Societal pluralism is another factor which affects the business. A society having various religions, culture, language, customs and tradition will turn against the business if any of these are disturbed. People will oppose establishment of a bar hotel near the place of worship or school. Recently, cheer girls were borrowed by the Indian Premier League for dancing in the cricket field, many of the social organsations opposed to it and even the Maharashtra Government threatened to ban the dance in that state. Another critical element is the social problems like the explosive growth of population, unemployment, poverty etc. consequent to the fall in death rate due to better health care system. Some of the African countries like Uganda; Nigeria etc. are suffering due to such problems. The business has to understand the social environment in which it exists and adjust its activities so as to avoid any clash with the social values and systems. The social development, industrialization process and management culture also affected the growth of business. The social developments include the trade union movements, consumer movements etc. While the trade union movements increased the bargaining power of employees, the consumer movement increased the bargaining power of consumers. The traditional system of managing agency which dominated the industrial activities in the country was abolished in 1969 and replaced with participative management, professional management and family owned business. The latest addition to these changes is the entry of multinational companies and foreign companies. Another important development is the changing role of shareholders. The shareholders have now become more powerful which made the corporate management more accountable. The corporate goal has now been re-written as shareholder wealth maximization.

The Environmental movements like Green Peace Activities also play a decisive role in the industrial growth. The responsibility of the business to maintain the ecological balance while expanding their business has increased substantially and the corporate entities are now made accountable for ecological violations. The unscientific usage of natural resources has resulted into its depletion and the large scale industrial expansion became a cause for the environmental deterioration. Some of the major issues the human race now faces are the global warming, industrial pollution, ecological imbalances etc. The rivers have become dry and the ground water resources have been dried up due to the excessive industrial pollution. Another matter of concern is the indiscriminate use of chemicals in industrial processes which caused fatal deceases like cancer. The use Endosulphan in the Northern Districts of Kerala like Kannur, Kazaragode etc. became a controversial issue as the people in the locality was affected by skin deceases. Another example is the industrial pollution created by the erstwhile Gwaliyor Rayons at Mavoor neat Kozhikode. The unit was ultimately closed. Another recent example is the closure of the Coco cola Plant in Plachimada near Palakkad due to the indiscriminate use of ground water which resulted into agitation by the social activitists like Medha Patkar and the local people. . Environmental protection and proper management of the ecology is absolutely necessary for sustainable development. Government has brought out various policy measures to protect the environment. Some of these measures include identification 17 highly polluting industries, prescribing emission norms for vehicles and insistence of compulsory emission testing certificate, drawing up Environmental Action Plan etc. The business also is expected to contribute from their part for the sustainable development. The corporate social responsibility (CSR) has become a globally accepted practice and companies now set apart a portion of their profit for the social benefit. The corporate entities are responsible to their stakeholders and society is one among such stakeholders because the corporate entities are using the resources which would have been otherwise available to the society. Therefore they are bound to return the cost of such resources to the society.

Conclusion
The business is functioning in an environment and has to interact with this environment frequently. The environment can be classified as internal and external environment. The environment can be global environment and domestic environment. The domestic environment can be further classified into economic environment, socio-cultural environment and politico-legal environment. Each of these categories has critical elements. The economic environment can be macro economic environment and micro environment. The critical elements of macro-economic environment are economic systems, nature of the economy, anatomy of the economy, functioning of the economy, economic planning and programmes, economic policy statements and proposals, economic control and regulations, economic legislations, economic trends and structure and economic problems and prospects. The micro-economic factors are organization specific. The critical elements of socio-cultural environment are social institutions and systems, social values and attitudes, education and culture, role and responsibility of the government, social groups and movements, socio-economic order and social problems and prospects. Lastly the critical elements of politico-legal environment are the form of government, ideology of the ruling party, strength of opposition, role and responsibility of the bureaucracy, political stability, velocity of the government policies, plans and programmes, socio-economic legislations and politico-legal institutions. No business can exist by ignoring the environment. There fore the business decision making process should involve the environment analysis also so as to ensure that the decisions do not work against the interest of the environment.

IMPACT OF UNION BUDGET ON CAPITAL MARKET

Article 112 of Constitution of India stipulates that a statement of estimated receipts and payments of the government relating to every financial year has to be laid before the Parliament. Consequently the finance minister presents the budget for the ensuing year together with a review for the reporting year before the Parliament. The process of budgeting starts as early as August and would be complete by the end of January. The finance minister usually holds discussions with the representatives of trade and industry in order to assess the expectations of the industrial and business sector.

The budget has two parts, the revenue account and the capital account. These two heads are again divided into plan and non-plan. The revenue account shows the revenue receipts like taxes, duties and other revenues due to the government. Revenue expenditures include the expenses incurred by the government for running the administration. Broadly speaking all the expenditures, which do not create any asset, can be classified as revenue expenditure. Capital budget on the other hand includes only capital receipts like loans raised externally and internally and capital payments which includes the payments made for acquisition of assets, investments etc.

The expenditure can be plan expenditure or non-plan expenditure. Plan expenditure represents the amount set apart for meeting the expenses connected with various central plans as well as assistance given to states to implement state plans. Non- plan expenditure includes interest payments, expenses for running the administration, grants and assistance to state governments, grants for foreign governments etc. on the revenue side and loans to state governments, defence etc. on the capital front.

A deficit arises when the estimated expenses are more than the estimated receipts. The deficits are classified into revenue deficit, fiscal deficit and primary deficit. Revenue deficit is arrived at by deducting the revenue receipts from the revenue expenditure. On the other hand a surplus arises if the revenue receipts are more than the revenue expenditure. Fiscal deficit is calculated by deducting the revenue receipts, recoveries of loans and other receipts from the total expenditure. Primary deficit is obtained by deducting interest payments from the fiscal deficit.

A growing fiscal deficit indicates the insufficiency of the income to meet the expenditure. The governments therefore resort to various deficit-financing techniques. This can be either by printing of additional currencies or by increasing the market borrowings by the governments. The first step expands the money supply and leads to inflationary pressures on the economy. The second step leads to increase in interest rates. In both cases the capital market can have an impact. When there is a deficit budget the cost of operations of corporate entities can go up because of two reasons. The government will either increase the taxes and duties to meet the deficit or borrow from the market resulting into increase in borrowing cost. As a result the cost of operation of the companies increases and they have to either increase the price of their products to retain the profit. The reduced profit can bring down the prices of shares of the companies and the market can exhibit a bear tendency.

BALANCE OF PAYMENT AND CAPITAL MARKET

Balance of Payment (BoP) of a country shows that country’s exposure to the external world. Briefly, BoP is the statement of assets and liabilities of a country as at the end of a certain date from/to the other countries in the world. When the receipts are more and the payments are less the BoP is said to be surplus. Similarly, if the payments are more, the BoP is said to be deficit.

BoP is divided into three parts. Initially, BoP is divided into current account and capital account. The current account is further broken into trading account and invisibles. Trading account shows purely trading transactions with the other countries. The difference between a country’s export and import is reflected in the trading account. When the import is more than export, the trade deficit arises and exports overtaking imports results into trade surplus.

Current account represents the trade transactions plus the invisibles. The invisibles have three parts viz. the services, transfers and income. Services include the travel, transportation, insurance, G.n.i.e( Government not included elsewhere) which include software services. Transfers are private or official. Income includes the investment income such as interest, dividend etc. and compensation to employees G.n.i.e represents the amount spent on the personnel deputed abroad on assignment like UN, reimbursement of expenses on personnel deputed to India from abroad etc. The balance in current account can be a deficit or surplus. A deficit in current account occurs when the payments overtake the receipts. When country is having excessive borrowings, the debt servicing becomes costly and this can take the current account to a deficit. The excessive dependence on cross-border borrowings takes place due to low domestic capital formation, which is the outcome of low domestic savings. Therefore, theoretically, the domestic savings and current account balance has some connection.

The capital account on the other hand represents all capital remittances. The capital account transactions are divided into long term and short term transactions. The long term transactions are direct investments abroad, direct foreign investments portfolio investments and loans. The loans are official and private and only the net balance is shown. The balance of current account plus the balance of long term capital account shows the basic balance. The short term transactions involve the holdings with banks and other short term transactions. The overall balance is arrived at by adjusting the errors and omissions.

Another important component of Balance of Payment is the official reserves. The foreign exchange reserves represent the balancing figure and include SDR allocations by IMF and net official reserves. The balance of payment is said to be in equilibrium when a surplus of deficit is eliminated. Equilibrium is a rare phenomenon and common feature is disequilibrium. When the balance of payment of a country moves adversely, the IMF helps that country to switch over the crisis through external assistance. This can be either through SDR allocation or a currency loan. Generally,

INFLATION MANAGEMENT

Inflation continues to be a headache for countries across the world and governments from time to time have been striving hard to contain inflation. India is not an exception to this situation. Inflationary pressures on Indian economy has been aggressive during the past around one year and the Reserve Bank of India had to initiate stern measures to arrest its journey upward further. The latest among these steps are the revision of CRR and Repo rates. This is not the first time Reserve bank of India is using Repo as an intervention tool to contain inflation. In the past also RBI had changed the Repo and Reverse Repo rates to adjust the excessive money supply. These rates increase the cost of funds of borrowers since the banks are compelled to increase their lending rates to absorb the drain in liquidity and to reduce the demand. However, in a developing country like India, the increase in lending rates automatically push forward the deposit rates also which attracts surplus funds. Though this would accelerate capital formation, in an open economy, the higher interest rate would attract funds from abroad also, thus again increasing the money supply in the domestic market. The large inflow of foreign funds will definitely help the country to build up their foreign exchange, but it would be a bane to the exporters due to appreciation of the domestic currency. The inflation also affects the net return. For example if the current interest on deposits is 5.25 per cent and the inflation rate is 6 percent, the effective rate is –0.75 per cent, in other words, it produces negative result. In the case of credit, the rate increases as inflation goes up. However, higher borrowing cost increases the ultimate cost of the product to the consumers. The increase in price in the short-term market will induce the producers and traders to withhold the product from the market so as to get a higher price. The farm products, especially potato, onion etc. have a considerable say in the Indian wholesale price index. Coming to the capital market, the inflation did not do much harm and the market again started moving upwards. Despite having increased the cost to borrowers, people have money with them. Though the government is initiating various measures to bring down the inflation, the present plans are insufficient to meet this objective as evidenced by the frequent mid-course corrections. Unless the money with the public could be pulled down, the inflationary pressures will accumulate.

FINANCIAL SECTOR REFORMS IN INDIA

Indian economy witnessed drastic changes in its policies and performance since 1991.The year 1990 was a turn around period for the Indian economy. The country’s economy was in a bad shape and the foreign exchange reserve was just sufficient to meet the import bill for hardly three months. Consequently, the government of India had decided to pledge a part of the gold reserve with Bank of England to meet the immediate foreign exchange government. Growing fiscal deficit continued to the major concern over all governments. The beginning of 1990s witnessed a change in the central government and the immediate task before the new administrators was to put the economy back on rails. Even before that much effort was put on formalizing the monetary policy and developments. The first move was the appointment of a Committee to Review the Working of Monetary System headed by Prof. Sukhamoy Chakravarty. The Committee had suggested that the monetary authority should go for monetary targeting in a more formal manner. Based on the recommendations of the Committee, Reserve Bank introduced a monetary policy frame work targeting M3 as a nominal anchor.

Working Group on Money Market (Vaghul Committee)

The second initiative was the appointment of a Working Group on Money Market headed by N.Vaghul which submitted its report in 1987. The major recommendations of the committee were:
Widening and deepening of the money and government securities market by selective increase in the number of participants
Introduction of well-diversified mix of instruments suited to the different requirements of borrowers and lenders
Gradual shift from administered interest regime to market determined interest rates
Establishment of a new set of institutions to provide active and vibrant secondary market for money and securities and also to impart sufficient liquidity to the system.
Based on these recommendations two important measures were initiated to strengthen and streamline the money and securities markets in the country. The first step was intended to encourage secondary market operations for which the maximum coupon rate was raised from 6.5 per cent 1977-78 to 11.5 per cent in 1985-86 and simultaneously the maximum maturity period was reduced from 30 years to 20 years. For the first time, Reserve Bank introduced 180 days Treasury Bill in 1986. Another step taken to encourage the secondary market operations was the establishment of Discounting and Finance House of India Ltd. (DFHI) jointly by Reserve Bank of India, public sector banks and all India financial institutions.

The second set of measures was for strengthening money market. These measures included (i) withdrawal of interest rate ceiling for all operations in the call/notice money market and also on rediscounting of commercial bills, (ii) granting permission of GIC, IDBI and NABARD as also the 13 financial institutions which were operating in the Bill Rediscounting Scheme to enter the call/notice money market as lenders, (iii) granting permissions to certain NBFCs to enter the call money market as lenders through DFHI (iv) introduction of the new money market instruments viz. Certificate of Deposit (CD), Commercial Paper (CP) and the Interbank Participation Certificates.

Committee on the Financial System (Narasimham Committee I)
Measures for strengthening the economy continued in the 1990s also. The financial sector being the nerve centre of the economy needed a thorough revamping. Accordingly in 1991, the government appointed The Committee on the Financial System headed by the M. Narasimham, the then Dy. Governor of Reserve Bank of India, popularly known as Namrasimham Committee I. The Committee had put forward comprehensive proposals for reforms in the area of banking, capital market and their regulation. The Committee’s recommendations gave greater emphasis on operational flexibility, functional autonomy, and greater degree of professionalism in management with a view to enhance productivity, efficiency and profitability in the banking and financial system in India. The major recommendations of the committee were:

Restructuring of the Banking System: The banking system in the country has to be consolidated to a four-tier structure consisting of
International banks - three or four large banks including State Bank of India,
Universal banking – eight to ten national banks with a network of branches through out the country,
Local banks- the operations of these banks should be confined to a specific region
Rural Banks (including Regional Rural Banks)- the operations should be confined to rural areas and business should be predominantly engaged in financing of agriculture and allied activities.
Liberal Banking Expansion Policy: Complete stoppage of nationalization of banks and encourage private sector banks to grow and entry of more banks in the private sector. Abolish the branch expansion policy leave the decision regarding opening and closing of branches to the commercial judgment of individual banks. RBI policy should be liberal so as to encourage foreign banks to open branches and subsidiaries in India.
Abolition of Discriminatory Policy in Promoting Banking: There should not be any discrimination between public sector and private sector banks and Indian banks Vs Foreign banks. While permitting foreign banks to operate in India, the same requirements as applicable to Indian banks should be made applicable to them also. The policy should also encourage joint venture by Indian and foreign banks in the areas of merchant and investment banking, leasing and other financial services.
Enhancement of Capital Base of Banks: The banks and financial institutions should achieve a minimum of 4 per cent Capital Adequacy Ratio to risk-weighted assets by March 1993 and 8 per cent by March 1996. The profitable banks should be encouraged to enhance their capital base by issuing fresh capital to the public through capital market.
Deregulation of Interest Rates: The interest rates on loans should be deregulated immediately and that on Government Borrowings should be deregulated gradually to bring in line with the market-determined rates. The interest rates on bank deposits should continue to be regulated.
Rationalization of Interest Rate Structure: The interest rate should be broadly aligned with the Bank Rate and the latter should be used as an anchor rate to signal RBI’s monetary policy stance. It is desirable to provide for a prime rate (the minimum lending rate of commercial banks). The spread between Bank Rate, deposit rates of banks, the Government borrowing rates and prime rate may be determined by RBI in accordance with the criteria laid down by the Chakravarty Committee so as to ensure that the real rates of interest remain positive.
Phasing out of Directed Credit Programmes: The directed credit programmes like lending to priority sectors should be withdrawn in a phased manner and the priority sector should be redefined to include small and marginal farmers, the tiny sector of the industry, village and cottage industries, rural artisans, small business, transport operators and other weaker sections. The credit target to these redefined priority sectors should be fixed at 10 per cent of the aggregate credit. The directed credit programmes should be reviewed after three years or so in order to assess the need to continue or withdraw the programmes.
Phasing out of Directed Investments:: Statutory Liquidity Ratio (SLR) should be reduced to 25 per cent in a phased manner over a period of five years starting from 1991 and should reduce the Cash Reserve Ratio (CRR) also progressively from its high level prevalent at that time. Reserve Bank should pay interest on impounded deposits of banks above the basic minimum at a rate equivalent to the level of bank’s one year deposit rate.
Setting up Tribunals to Speed up the Process of Recovery: Special Tribunal in the lines recommended by Tiwari Committee should be set up to speed up the process of recovery of overdues in banks.
Provision for Doubtful Debts and Sub-standard Assets: Banks should create a general provision equal to 10 per cent of the total outstanding sub-standard assets and 100 per cent of the security shortfall in respect of the doubtful debts.
Asset Reconstruction Funds: An Asset Recovery Fund should be crated for taking over a portion of bad and doubtful debts from banks and financial institutions at a discount. Banks could recycle these funds into more productive assets.
RBI’s Role as Regulatory Authority: Dual control over banking system by RBI and the Banking Division of Ministry of Finance should be abolished and RBI should be made the sole regulatory authority for the banking system. For this purpose as separate Board for Financial Supervision should be established under RBI.
Liberalization of Capital Market: The requirement of prior approval of SEBI or Government for any issue on the capital market should be scrapped and companies should have the freedom to decide on the instrument (shares and bonds), its terms and pricing.

The process of liberalization, privatization and globalization of Indian economy necessitated reforms in the banking and financial sectors too. Accordingly almost all the recommendations made by the Narasimham Committee were accepted. Consequently Reserve Bank had implemented measures such as reduction of SLR and CRR, deregulation of lending rates, deregulation of interest rates on deposits, capital adequacy norms, prudential norms, establishment of new private sector banks with capital contribution from Foreign Institutional Investors up to 20 per cent and NRIs up to 40 per cent, freedom for opening new branches and upgrading extension counters for those banks which have attained capital adequacy norms and prudential accounting standards, passing of Recovery of Debts and Special Recovery Tribunals Act 1993 and establishment of five Tribunals at Calcutta, Delhi, Ahmedbad, Jaipur and Bangalore and one Appellate Tribunal at Mumbai, setting up of Board of Financial Supervision at RBI and recapitalization less strong public sector banks through budgetary support.
Having implemented the first generation reforms in the banking and financial sector, the government proceeded with the launching of the second generation reforms. In order to study the second generation reforms, government appointed a Study Group headed by M. Narasimham (Narasimham Committee II) to examine three broadly related issues : (i) strengthening the foundation of banking system, (ii) Streamlining procedures, Upgrading technologies and Human resource development and (iii) structural changes in the system. The Committee submitted its report covering the areas such as banking policy, institutional supervisory and legislative initiatives. Their major recommendations on which RBI had initiated action were:

Measures to Strengthen the Banking System[1]
A. Capital Adequacy

1. Pending the emergence of markets in India where market risks can be covered, it would be desirable that capital adequacy requirements take into account market risks in addition to the credit risks.
2. In the next three years, the entire portfolio of Government securities should be marked to market and this schedule of adjustment should be announced at the earliest. It would be appropriate that there should be a 5% weight for market risk for Govt. and approved securities.
3. The risk weight for a Government guaranteed advance should be the same as for other advances. To ensure that banks do not suddenly face difficulties in meeting the capital adequacy requirement, the new prescription on risk weight for Government guaranteed advances should be made prospective from the time the new prescription is put in place
4. There is an additional capital requirement of 5% of the foreign exchange open position limit. Such risks should be integrated into the calculation of risk weighted assets. The Committee recommends that the foreign exchange open position limits should carry a 100% risk weight.
5. The minimum capital to risk assets ratio be increased to 10% from its present level of 8%. It would be appropriate to phase the increase as was done on the previous occasion. Accordingly an intermediate minimum target of 9% be achieved by the year 2000 and the ratio of 10% by 2002. The RBI should also have the authority to raise this further in respect of individual banks if in its judgement the situation with respect to their risk profile warrants such an increase. The issue of individual banks' shortfalls in the CRAR needs to be addressed in much the same way that the discipline of reserve requirements is now applied, viz., of uniformity across weak and strong banks.

B. Asset Quality, NPAs and Directed Credit

1. An asset be classified as doubtful if it is in the substandard category for 18 months in the first instance and eventually for 12 months and loss if it has been so identified but not written off. These norms, which should be regarded as the minimum, may be brought into force in a phased manner. 90 days norm for income recognition should be introduced in a phased manner.
2. The Committee has noted that NPA figures do not include advances covered by Government guarantees which have turned sticky and which in the absence of such guarantees would have been classified as NPAs. The Committee, therefore recommended that for the purposes of evaluating the quality of asset portfolio such advances should be treated as NPAs. If , however, for reason of the sovereign guarantee argument such advances are excluded from computation, the Committee recommended that Government guaranteed advances which otherwise would have been classified as NPAs should be separately shown as an aspect of fuller disclosure and greater transparency of operations.
3. Banks and financial institutions should avoid the practice of "evergreening" by making fresh advances to their troubled constituents only with a view to settling interest dues and avoiding classification of the loans in question as NPAs. The Committee noted that the regulatory and supervisory authorities are paying particular attention to such breaches in the adherence to the spirit of the NPA definitions and are taking appropriate corrective action. At the same time, it was found necessary to resist the suggestions made from time to time for a relaxation of the definition of NPAs and the norms in this regard
4. The objective should be to reduce the average level of net NPAs for all banks to below 5% by the year 2000 and to 3% by 2002. For those banks with an international presence the minimum objective should be to reduce gross NPAs to 5% and 3% by the year 2000 and 2002, respectively, and net NPAs to 3% and 0% by these dates. These targets cannot be achieved in the absence of measures to tackle the problem of backlog of NPAs on a one time basis and the implementation of strict prudential norms and management efficiency to prevent the recurrence of this problem.
5. Any effort at financial restructuring in the form of hiving off the NPA portfolio from the books of the banks or measures to mitigate the impact of a high level of NPAs must go hand in hand with operational restructuring. Cleaning up the balance sheets of banks would thus make sense only if simultaneously steps were taken to prevent or limit the re-emergence of new NPAs which could only come about through a strict application of prudential norms and managerial improvement.
6. For banks with a high NPA portfolio, the Committee suggested consideration of two alternative approaches to the problem as an alternative to the ARF proposal made by the earlier CFS. In the first approach, all loan assets in the doubtful and loss categories - which in any case represent bulk of the hard core NPAs in most banks should be identified and their realisable value determined. These assets could be transferred to an Asset Reconstruction Company (ARC) which would issue to the banks NPA Swap Bonds representing the realisable value of the assets transferred, provided the stamp duties are not excessive. The ARC could be set up by one bank or a set of banks or even in the private sector. In case the banks themselves decide to set up an ARC, it would need to be ensured that the staff required by the ARC is made available to it by the banks concerned either on transfer or on deputation basis, so that staff with institutional memory on NPAs is available to ARC and there is also some rationalisation of staff in the banks whose assets are sought to be transferred to the ARC. Funding of such an ARC could be facilitated by treating it on par with venture capital for purpose of tax incentives. Some other banks may be willing to fund such assets in effect by securitising them. This approach would be worthwhile and workable if stamp duty rates are minimal and tax incentives are provided to the banks.
7. An alternative approach could be to enable the banks in difficulty to issue bonds which could form part of Tier II capital. This will help the banks to bolster capital adequacy which has been eroded because of the provisioning requirements for NPAs. As the banks in difficulty may find it difficult to attract subscribers to bonds. Government will need to guarantee these instruments which would then make them eligible for SLR investments by banks and approve instruments by LIC, GIC and Provident Funds.
8. The Committee observed that directed credit has a proportionately higher share in NPA portfolio of banks and has been one of the factors in erosion in the quality of bank assets. There is continuing need for banks to In this process, there is scope for correcting the distortions arising out of directed extend credit to agriculture and small scale sector which are important segments of the national economy, on commercial considerations and on the basis of creditworthiness. credit and its impact on banks’ assets quality.
9. Considering the problems of small and marginal farmers, tiny sector of industry and small businessmen, and given the special needs of these sectors, the Committee recommended to continue the practice of lending of 40 per cent of net bank credit to priority sectors. . The Branch Managers of banks should, however, be fully responsible for the identification of beneficiaries under the Government sponsored credit linked schemes. The Committee proposes that given the importance and needs of employment oriented sectors like food processing and related service activities in agriculture, fisheries, poultry and dairying, these sectors should also be covered under the scope of priority sector lending. The Committee recommends that the interest subsidy element in credit for the priority sector should be totally eliminated and even interest rates on loans under Rs.2 lakh should be deregulated for scheduled commercial banks as has been done in the case of Regional Rural Banks and co-operative credit institutions. The Committee believes that it is the timely and adequate availability of credit rather than its cost which is material for the intended beneficiaries. The reduction of the pre-empted portion of banks' resources through the SLR and CRR would, in any case, enlarge the ability of banks to dispense credit to these sectors.

C. Prudential Norms and Disclosure Requirements

1. With regard to income recognition, in India, income stops accruing when interest or installment of principal is not paid within 180 days. Therefore Committee recommended that we should move towards international practices in this regard and should introduce the norm of 90 days in a phased manner by the year 2002.
2. Considering that at present, there is no requirement in India for a general provision on standard assets, the Committee suggested that RBI should consider introduction a general provision, say, of 1% in a phased manner.
3. The Committee was of the view that in the case of future loans, the income recognition and asset classification and provisioning norms should apply even to Government guaranteed advances in the same manner as for any other advance. For existing Government guaranteed advances, RBI, Government and banks may work out a mechanism for a phased rectification of the irregularities in these accounts.
4. The Committee identified a need for disclosure, in a phased manner, of the maturity pattern of assets and liabilities, foreign currency assets and liabilities, movements in provision account and NPAs. The RBI should direct banks to publish, in addition to financial statements of independent entities, a consolidated balance sheet to reveal the strength of the group. Full disclosure would also be required of connected lending and lending to sensitive sectors. Furthermore, it should also ask banks to disclose loans given to related companies in the bank's balance sheets. Full disclosure of information should not be only a regulatory requirement. It would be necessary to enable a bank’s creditors, investors and rating agencies to get a true picture of its functioning – an important requirement in a market driven financial sector.
5. Banks should also pay greater attention to asset liability management to avoid mismatches and to cover, among others, liquidity and interest rate risks.
6. Banks should be encouraged to adopt statistical risk management techniques like Value-at-Risk in respect of balance sheet items which are susceptible to market price fluctuations, forex rate volatility and interest rate changes. While the Reserve Bank may initially, prescribe certain normative models for market risk management, the ultimate objective should be that of banks building up their own models and RBI backtesting them for their validity on a periodical basis.

D. Systems and Methods in Banks

1. Banks should bring out revised Operational Manuals and update them regularly, keeping in view the emerging needs and ensure adherence to the instructions so that these operations are conducted in the best interest of a bank and with a view to promoting good customer service. These should form the basic objective of internal control systems, the major components of which are : (I) Internal Inspection and Audit, including concurrent audit, (2) Submission of Control Returns by branches/controlling offices to higher level offices (3) Visits by controlling officials to the field level offices (4) Risk management systems (5) Simplification of documentation, procedure and of inter office communication channels.
2. An area requiring close scrutiny in the coming years would be computer audit, in view of large scale usage and reliance on information technology.
3. There is enough international experience to show the dangers to an institution arising out of inadequate reporting to and checking by the back offices of trading transactions and positions taken. Banks should pay special attention to this aspect.
4. There is need to institute an independent loan review mechanism especially for large borrowal accounts and systems to identify potential NPAs. It would be desirable that banks evolve a filtering mechanism by stipulating in-house prudential limits beyond which exposures on single/group borrowers are taken keeping in view their risk profile as revealed through credit rating and other relevant factors. Further, in-house limits could be thought of to limit the concentration of large exposures and industry/sector/geographical exposures within the Board approved exposure limits and proper overseeing of these by the senior management/ boards.
5. The Committee recommended that RBI may review its present practice of selection of statutory auditors for banks with Board of Directors having no role in the appointment process, since it was not conducive to sound corporate governance. It may also reassess the role and function of the Standing Advisory Committee on Bank Audit in the light of the setting up of the Audit Committee under the aegis of the Board for Financial Supervision.
6. The Committee noted that public sector banks and financial institutions have yet to introduce a system of recruiting skilled manpower from the open market. The Committee believed that this delay has had an impact on the competency levels of public sector banks in some areas and they have consequently lost some ground to foreign banks and the newly set up private sector banks. The Committee therefore, urged that this aspect be given urgent consideration and in case there was any extant policy driven impediments to introducing this system, appropriate steps be taken by the authorities towards the needed deregulation. Banks were advised to tone up their skills base by resorting, on an ongoing basis, to lateral induction of experienced and skilled personnel, particularly for quick entry into new activity/areas. The Committee noted that there had been considerable decline in the scale of merit-based recruitment even at the entry level in many banks. The concept of direct recruitment itself was found considerably diluted by many PSBs including the State Bank of India by counting internal promotions to the trainee officers’ cadre as direct recruitment. The Committee strongly urged the managements of public sector banks to take steps to reverse this trend. The CFS had recommended that there was no need for continuing with the Banking Service Recruitment Boards insofar as recruitment of officers was concerned. This Committee, upon examination of the issue, reaffirmed that recommendation. As for recruitment in the clerical cadre, the Committee recommended that a beginning be made in this regard by permitting three or four large well-performing banks, including State Bank of India, to set up their own recruitment machinery for recruiting clerical staff. If the experience under this new arrangement proved satisfactory, it could then pave the way for eventually doing away completely with the Banking Service Recruitment Boards.
7. The Committee observed that there were varying levels of overmanning in public sector banks. The managements of individual banks were required initiate steps to measure what adjustments in the size of their work force was necessary for the banks to remain efficient, competitive and viable. Surplus staff, where identified, would need to be redeployed on new business and activities, where necessary after suitable retraining. It is possible that even after this some of the excess staff might not be suitable for redeployment on grounds of aptitude and mobility. The Committee, therefore, suggested to introduce an appropriate Voluntary Retirement Scheme with incentives. The managements of banks were advised to initiate dialogue in this area with representatives of labour. The Committee urged the managements of Indian banks to review the changing training needs in individual banks keeping in mind their own business environment and to address these urgently.
8. Globally, banking and financial systems have undergone fundamental changes because of the ongoing revolution in information and communications technology. Information technology and electronic funds transfer systems have emerged as the twin pillars of modern banking development. This phenomenon has largely bypassed the Indian banking system although most technologies that could be considered suitable for India have been introduced in some diluted form. The Committee felt that requisite success in this area has not been achieved because of the following reasons:

· Inadequate bank automation.
· Not so strong commercially oriented inter-bank platform.
· Lack of a planned, standardised, electronic payment systems backbone.
· Inadequate telecom infrastructure.
· Inadequate marketing effort.
· Lack of clarity and certainty on legal issues and
· Lack of data warehousing network.

The Committee has tried to list out series of implementation steps for achieving rapid induction of information technology in the banking system. Further, information and control systems need to be developed in several areas like

· Better tracking of spreads, costs and NPAs for higher profitability.
· Accurate and timely information for strategic decisions to identify and promote profitable products and customers.
· Risk and Asset-Liability management; and
· Efficient Treasury management.

E. Structural Issues

1. The Committee recommended that there should be only two forms of intermediaries, viz. banking companies and non-banking finance companies. If a DFI does not acquire a banking licence within a stipulated time it would be categorised as a non-banking finance company. A DFI which converts to a bank can be given some time to phase in reserve requirements in respect of its liabilities to bring it on par with the requirements relating to commercial banks. Similarly, as long as a system of directed credit is in vogue a formula should be worked out to extend this to DFIs which have become banks.
2. . Mergers between banks and between banks and DFIs and NBFCs need to be based on synergies and locational and business specific complementarities of the concerned institutions and must obviously make sound commercial sense. Mergers of public sector banks should emanate from management of banks with Govt. as the common shareholder playing a supportive role. Such mergers, however, can be worthwhile if they lead to rationalisation of workforce and branch network; otherwise the mergers of public sector banks would tie down the managements with operational issues and distract attention from the real issue. It would be necessary to evolve policies aimed at "rightsizing" and redeployment of the surplus staff either by way of retraining them and giving them appropriate alternate employment or by introducing a VRS with appropriate incentives. This would necessitate the co-operation and understanding of the employees and towards this direction, managements should initiate discussions with the representatives of staff and would need to convince their employees about the intrinsic soundness of the idea, the competitive benefits that would accrue and the scope and potential for employees' own professional advancement in a larger institution. Mergers should not be seen as a means of bailing out weak banks. Mergers between strong banks/FIs would make for greater economic and commercial sense and would be a case where the whole is greater than the sum of its parts and have a "force multiplier effect".
3. A ‘weak bank’ should be one whose accumulated losses and net NPAs exceed its net worth or one whose operating profits less its income on recapitalisation bonds is negative for three consecutive years. A case by case examination of the weak banks should be undertaken to identify those which are potentially revivable with a programme of financial and operational restructuring. Such banks could be nurtured into healthy units by slowing down on expansion, eschewing high cost funds/borrowings, judicious manpower deployment, recovery initiatives, containment of expenditure etc. The future set up of such banks should also be given due consideration. Merger could be a solution to the problem of weak banks but only after cleaning up their balance sheets. If there is no voluntary response to a take over of these banks, it may be desirable to think in terms of a Restructuring Commission for such public sector banks for considering other options including restructuring, merger amalgamation or failing these closure. Such a Commission could have terms of reference which, inter alia, should include suggestion of measures to safeguard the interest of depositors and employees and to deal with possible negative externalities. Weak banks which on a careful examination are not capable of revival over a period of three years, should be referred to the Commission.
4. The policy of licensing new private banks (other than local area banks) may continue. The start up capital requirements of Rs.100 crore were set in 1993 and these may be reviewed. The Committee recommended that there should be well defined criteria and a transparent mechanism for deciding the ability of promoters to professionally manage the banks and no category should be excluded on a priori grounds. The question of a minimum threshold capital for old private banks also deserves attention and mergers could be one of the options available for reaching the required capital thresholds. The Committee also therefore, suggested that as long as it is laid down (as now) that any particular promoter group cannot hold more than 40% of the equity of a bank, any further restriction of voting rights by limiting it to 10% may be done away with.
5. The Committee expressed its view in favour of foreign banks setting up subsidiaries or joint ventures in India. Such subsidiaries or joint ventures should be treated on par with other private banks and subject to the same conditions with regard to branches and directed credit as these banks.
6. All NBFCs were statutorily required to have a minimum net worth of Rs.25 lakhs if they were to be registered. The Committee recommended that this minimum figure should be progressively enhanced to Rs.2 crores which is permissible now under the statute and that in the first instance it should be raised to Rs.50 lakhs.
7. The Committee did not favour extending the deposit insurance cover to Non-banking Finance Companies.
8. RBI should undertake a review of the current entry norms for urban cooperative banks and prescribe revised prudent minimum capital norms for these banks. Though cooperation is a state subject, since UCBs are primarily credit institutions meant to be run on commercial lines, the Committee recommended that this duality in control should be dispensed with. It should be primarily the task of the Board of Financial Supervision to set up regulatory standards for Urban Cooperative Banks and ensure compliance with these standards through the instrumentality of supervision.
9. The Committee observed that there was need for a reform of the deposit insurance scheme. In India, deposits are insured upto Rs.1 lakh. While there was no need to increase the amount further, there existed, however, need to shift away from the 'flat' rate premiums to 'risk based' or 'variable rate' premiums. Under risk based premium system all banks would not be charged a uniform premium. While there could be a minimum flat rate which would have to be paid by all banks on all their customer deposits, institutions which had riskier porfolios or which had lower ratings should pay higher premium. There would thus be a graded premium. As the Reserve Bank was awarding CAMELS ratings to banks, these ratings could form the basis for charging deposit insurance premium.
10. The Committee recommended that the inter-bank call and notice money market and inter-bank term money market should be strictly restricted to banks. The only exception should be the primary dealers who, in a sense, perform a key function of equilibrating the call money market and are formally treated as banks for the purpose of their inter-bank transactions. All the other non-bank participants in the inter-bank call money market should not be provided access to the inter-bank call money market. These institutions could be provided access to the money market through different segments.
11. There must be clearly defined prudent limits beyond which banks should not be allowed to rely on the call money market. This would reduce the problem of vulnerability of chronic borrowers. Access to the call market should be essentially for meeting unforeseen swings and not as a regular means of financing banks’ lending operations.
12. The RBI support to the market should be through a Liquidity Adjustment Facility under which the RBI would periodically, if necessary daily, reset its Repo and Reverse Repo rates which would in a sense provide a reasonable corridor for market play. While there was much merit in an inter-bank reference rate like a LIBOR, such a reference rate would emerge as banks implement sound liquidity management facilities and the other suggestions made above are implemented. Such a rate could not be anointed, as it had to earn its position in the market by being a fairly stable rate which signaled small discrete interest rate changes to the rest of the system.
13. The minimum period of FD should be reduced to 15 days and all money market instruments should likewise have a similar reduced minimum duration.
14. Foreign institutional investors should be given access to the Treasury Bill market. Broadening the market by increasing the participants would provide depth to the market.
15. With the progressive expansion of the forward exchange market, there should be an endeavour to integrate the forward exchange market with the spot forex market by allowing all participants in the spot forex market to participate in the forward market up to their exposures. Furthermore, the forex market, the money market and the securities should be allowed to integrate and the forward premia should reflect the interest rate differential. As instruments move in tandem in these markets the desiderative of a seamless and vibrant financial market would hopefully emerge.
16. The Committee also recommended that a distinction be made between NPAs arising out of client specific and institution specific reasons and general (agro-climatic and environmental issues) factors. While there should be no concession in treatment of NPAs arising from client specific reasons, any decision to declare a particular crop or product or a particular region to be distress hit should be taken purely on techno-economic consideration by a technical body like NABARD.
17. As a measure of improving the efficiency and imparting a measure of flexibility the committee recommended consideration of the debt securitisation concept within the priority sector. This could enable banks, which are not able to reach the priority sector target to purchase the debt from the institutions, which are able to lend beyond their mandated percentage.
18. Banking policy should facilitate the evolution and growth of micro credit institutions including LABs which focus on agriculture, tiny and small scale industries promoted by NGOs for meeting the banking needs of the poor. Third-tier banks should be promoted and strengthened to be autonomous, vibrant, effective and competitive in their operations.

F. Regulation and Supervision

1. The Committee recommended that to improve the soundness and stability of the Indian banking system, the regulatory authorities should make it obligatory for banks to take into account risk weights for market risks. The movement towards greater market discipline in a sense would transform the relationship between banks and the regulator. By requiring greater internal controls, transparency and market discipline, the supervisory burden itself would be relatively lighter.
2. Proprietorial concerns in the case of public sector banks impact on the regulatory function lead to a situation of ‘regulatory capture’ affecting the quality of regulation.
3. The Committee recommended that the regulatory and supervisory authorities should take note of the developments taking place elsewhere in the area of devising effective regulatory norms and to apply them in India taking into account the special characteristics but not in any way diluting the rigour of the norms so that the prescriptions match the best practices abroad. It is equally important to recognise that pleas for regulatory forbearance such as waiving adherence to the regulations to enable some (weak) banks more time to overcome their deficiencies could only compound their problems for the future and further emasculate their balance sheets.
4. An important aspect of regulatory concern should be ensuring transparency and credibility particularly as we move into a more market driven system where the market should be enabled to form its judgement about the soundness of an institution. There should be punitive penalties both for the inaccurate reporting to the supervisor or inaccurate disclosures to the public and transgressions in spirit of the regulations.
5. The Committee observed that banks should be required to publish half yearly disclosure requirements in two parts. The first should be a general disclosure, providing a summary of performance over a period of time, say 3 years, including the overall performance, capital adequacy, information on the bank’s risk management systems, the credit rating and any action by the regulator/supervisor. The disclosure statement should be subject to full external audit and any falsification should invite criminal procedures. The second disclosure, which should be a brief summary aimed at the ordinary depositor/ investor should provide brief information on matters such as capital adequacy ratio, non performing assets and profitability, vis-à-vis, the adherence to the stipulated norms and a comparison with the industry average. This summary should be in a language intelligible to the depositor and be approved by the supervisors before being made fully public when soliciting deposits. Such disclosure would help the strong banks to grow faster than the weaker banks and thus lead to systematic improvement.
6. The Board for Financial Regulation and Supervision (BFRS) should be given statutory powers and be reconstituted in such a way as to be composed of professionals. Though professional inputs were largely available in an advisory board which acted as a distinct entity supporting the BFS, statutory amendment would give the necessary powers to the BFRS which should develop its own autonomous professional character. The Committee, took note of the formation of BFS, recommended that the process of separating it from the Reserve Bank qua central bank should begin and the Board should be invested with requisite autonomy and armed with necessary powers so as to allow it to develop experience and professional expertise and to function effectively. However, with a view to retain an organic linkage with RBI, the Governor, RBI should be head of the BFRS. The Committee has also set out specific measures to ensure an effective regulatory/supervisory system.

G. Legal and Legislative Framework

1. With the advent of computerisation there existed need for clarity in the law regarding the evidentiary value of computer generated documents. The Shere Committee had made some recommendations in this regard and the Committee noted that the Government was having consultations with public sector banks in this matter. With electronic funds transfer several issues regarding authentication of payment instruments, etc. required to be clarified. The Committee recommended that a group be constituted by the Reserve Bank to work out the detailed proposals in this regard and implement them in a time bound manner.
2. Despite having a provision in our legislation effectively prohibiting loans by banks to companies in which their directors are interested as directors or employees of the latter with liberalisation and the emergence of more banks on the scene and with the induction of private capital through public issue in some of the nationalised banks there a possibility existed that the phenomenon of connected lending might reappear even while adhering to the letter of law. It was necessary to have prudential norms which are addressed to this problem by stipulating concentration ratios in terms of which no bank could hold more than a specified proportion of its net worth by way of lending to any single industrial concern and a higher percentage in respect of lending to an industrial group. The limit for lending to any single concern up to 25% of a bank’s capital and free reserves prevailed at that time was considered to be appropriate along with the an enhanced figure of 50% for group exposure except in the case of specified infrastructure projects. Similarly, concentration ratios would need to be indicated, even if not specifically prescribed, in respect of any bank’s exposure to any particular industrial sector so that in the event of cyclical or other changes in the industrial situation, banks have an element of protection from over exposure in that sector. Prudential norms would also need to be set by way of prescription of exposure limits to sectors particularly sensitive to asset price fluctuations such as stock markets and real estate. The Committee observed that Indian banks did not have much exposure to the real estate sector in the form of lending for property development as distinct from making housing loans. The example of banks in East and South East Asia which had over extended themselves to these two sectors has only confirmed the need for circumspection in this regard. The Committee left the precise stipulation of these limits and, if necessary, loan to collateral value ratios to the authorities concerned. The implementation of these exposure limits would need to be carefully monitored to see that they are effectively implemented and not circumvented, as has sometimes happened abroad, in a variety of ways. Another salutary prescription would be to require full disclosure of connected lending and lending to sensitive sectors.
3. The Committee recommended that to improve the soundness and stability of the Indian banking system, the regulatory authorities should make it obligatory for banks to take into account risk weights for market risks. The movement towards greater market discipline in a sense would transform the relationship between banks and the regulator. By requiring greater internal controls, transparency and market discipline, the supervisory burden itself would be relatively lighter.
4. The Committee recommended that the RBI should totally withdraw from the primary market in 91 days Treasury Bills; the RBI could, of course, have a presence in the secondary market for 91 days Treasury Bills. If the 91 days Treasury Bill rate reflected money market conditions, the money and securities market would develop an integral link. The Committee also recommended that foreign institutional investors should be given access to the Treasury Bill market.

These recommendations were implemented by the Reserve Bank of India in a phased manner. The decision regarding dispensation of Banking Service Recruitment Board (BSRB) was left to the government. While recruitment to Reserve Bank of India, State Bank of India and their Associate Banks are done independently by RBI and SBI respectively, the recruitment to nationalized banks to clerical and officers cadre are handled by the BSRB. However, lateral entries to higher positions are handled independently by the individual banks.

The following recommendations were referred to the government for taking appropriate action[2].

So far, a sum of Rs.20,000 crore has been expended for recapitalisation and to the extent to which recapitalisation has enabled banks to write off losses, this is the cost which the Exchequer has had to bear for the bad debts of the banks. Recapitalisation is a costly and, in the long run, not a sustainable option. Recapitalisation involves budgetary commitments and could lead to a large measure of monetisation. The Committee urged that no further recapitalisation of banks be undertaken from the Government budget. As the authorities have already proceeded on the recapitalisation route it is perhaps not necessary to consider de novo the institution of an ARF of the type envisaged by the earlier CFS Report. The situation would perhaps have been different if the recapitalisation exercise had not been undertaken in the manner in which it has been.
As an incentive to banks to make specific provisions, the Committee recommended that consideration be given to making such provisions tax deductible.
It would be appropriate if the management committees are reconstituted to have only whole time functionaries in it, somewhat on the pattern of Central Office Credit Committee constituted in the State Bank of India. All decisions taken by these committees could be put up to the Board of Directors for information.
It would be appropriate to induct an additional whole time director on the Board of the banks with an enabling provision for more whole time directors for bigger banks.
There are opportunities of outsourcing in other activities like building maintenance, cleaning, security, despatch of mail and more importantly, in computer related areas. The Committee has been informed that in some areas banks are unable to subcontract work because of a notification issued by the Labour Ministry under Contract Labour (Regulation and Abolition) Act, 1970. The Committee urged that this be looked into by the authorities so that banks are enabled to effect efficiency and productivity improvements. The global trend in the banking and financial sector also reflects an increasing reliance on outsourced services. In an increasingly competitive environment, statutory provisions should not lead to banks having to carry on internally functions and tasks which can be performed more efficiently by outside service provides.
The Committee felt that the issue of remuneration structure at managerial levels prevailing in public sector banks and financial institutions needs to be addressed. They also felt an urgent need to ensure that public sector banks are given flexibility to determine managerial remuneration levels taking into account market trends. The Committee recommended that the necessary authority in this regard be given to the Boards of the banks initially in the case of profit making public sector banks which have gone public, for they would, in any case, be required to operate with an accountability to the market. The forthcoming wage negotiations provide an opportunity to review the existing pattern of industry-wise negotiations and move over to bank-wise negotiations.
There might be need to redefine the scope of external vigilance and investigative agencies with regard to banking business. External agencies should have the requisite skill and expertise to take into account the commercial environment in which decisions are taken. The vigilance manual now being used has been designed mainly for use by Government Departments and public sector undertakings. It may be necessary that a separate vigilance manual which captures the special features of banking should be prepared for exercising vigilance supervision over banks. The Committee felt that this is an extremely critical area and arrangements similar to the Advisory Board for Bank Frauds be made for various levels of staff of banks.
The Committee attached the greatest importance to the issue of functional autonomy with accountability within the framework of purposive, rule bound, non-discretionary prudential regulation and supervision. The Committee considered autonomy as a prerequisite for operational flexibility and for critical decision making whether in terms of strategy or day to day operations. There was also the question whether full autonomy with accountability was consistent and compatible with public ownership. Given the dynamic context in which the banks were operating and considering the situational experience further capital enhancement would be necessary for the larger Indian banks. Against the background of the need for fiscal consolidation and given the many demands on the budget for investment funds in areas like infrastructure and social services, it could not be argued that subscription to the equity of public sector banks to meet their enhanced needs for capital should command priority. Public sector banks should be encouraged, therefore, to go to the market to raise capital to enhance their capital. As prevailing law not less than 51% of the share capital of public sector banks should be vested with the Government and similarly not less than 55% of the share capital of the State Bank of India should be held by the Reserve Bank of India.
The requirement of minimum Government of India/Reserve Bank of India shareholding at that time was likely to become a constraint for raising additional capital from the market by some of the better placed banks unless Government also decided to provide necessary budgetary resources to proportionately subscribe to the additional equity, including the necessary premium on the share price, so as to retain its minimum stipulated shareholding. The Committee believed that these minimum stipulations should be reviewed. It suggested that the minimum shareholding by Government/RBI in the equity of nationalised banks and SBI should be brought down to 33%.
The Reserve Bank as a regulator of the monetary system should not be also the owner of a bank in view of the potential for possible conflict of interest. It would be necessary for the Government/RBI to divest their stake in these nationalised banks and in the State Bank of India. A reduction in their shares would come about through additional subscription by the market to their enhanced capital. A portion of upto 5 or 10% of the equity of the bank concerned may be reserved for employees of the bank with a provision of some later date for the introduction of stock options. The appointment by the Government of Boards and top executives of banks derives from its majority holding and if, as suggested above, the majority holding itself were to be given up, the appointment of Chairmen and Managing Directors should be left to the Boards of the banks and the Boards themselves left to be elected by shareholders.
Needless to say, with a significant stock holding of not less than 33% Government would have a say in the election of Boards and indirectly of the chief executives without their being seen as administrative appointments. The reduction in the minimum holding of Government below 51% would in itself be a major and clear signal about the restoration to banks and financial institutions of autonomy in their functioning. The Committee made this recommendation in the firm belief that this is essential for enhancing the effectiveness and efficiency of the system and not on any other consideration.
To provide the much needed flexibility in its operations, IDBI should be corporatised and converted into a Joint Stock Company under the Companies Act on the lines of ICICI, IFCI and IDBI. For providing focused attention to the work of State Financial Corporations, IDBI shareholding in them should be transferred to SIDBI which is currently providing refinance assistance to State Financial Corporations. To give it greater operational autonomy, SIDBI should also be delinked from IDBI
Though cooperation is a state subject, since UCBs are primarily credit institutions meant to be run on commercial lines, the Committee recommended that this duality in control should be dispensed with. It should be primarily the task of the Board for Financial Supervision to set up regulatory standards for Urban Cooperative banks and ensure compliance with these standards through the instrumentality of supervision.
The Committee was of the view that the banking system should be in a position to equip itself to identify the eligible clients based on prescribed norms in the Government sponsored programmes so that the full responsibility for all aspects of the credit decision remained with it. This should also help improve the client bank relationship instead of the present system of virtually imposed clientele and build a credit culture and discipline .
The Committee strongly urged that there should be no recourse to any scheme of debt waiver in view of its serious and deleterious impact on the culture of credit.
Evolution of a risk management system would provide the needed comfort to the banking system to finance agriculture. Under the Income Tax Act, provision for bad and doubtful debts not exceeding 5% of income and 10% of the aggregate average advances made by rural branches of a scheduled or a non scheduled bank were allowed as deduction in computing the income chargeable to tax. Consideration could be given to increasing this to 5% of income and 20% of average aggregate advances of rural branches to provide incentive to banks for lending to rural sectors.
The Committee recommended that the RRBs and cooperative banks should reach a minimum of 8% capital to risk weighted assets over a period of five years. A review of the capital structure of RRBs should be undertaken with a view to enlarging public subscription and give the sponsor banks greater ownership and responsibility in the operation of RRBs. While considering the issue of salaries of employees of RRBs the Committee strongly urged that there should be no further dilution of the basic feature of RRBs as low cost credit delivery institutions. Cooperative credit institutions also need to enhance their capital through subscription by their members and not by Government. There should be a delayering of the cooperative credit institutions with a view to reducing the intermediation cost and thus providing the benefit of cheaper NABARD credit to the ultimate borrowers.
The supervisory function over rural financial institutions had been entrusted to NABARD. While this arrangement may continue for the present, over the longer term, the Committee suggested that all regulatory and supervisory functions over rural credit institutions should vest with the Board for Financial Regulation and Supervision.
The duality of control over the cooperative credit institutions by State Government and RBI/NABARD should be eliminated and all the cooperative banking institutions should come under the discipline of Banking Regulation Act, under the aegis of RBI/NABARD/BFS. Thus would require amendments to the Banking Regulation Act. The control of the Registrar of cooperative sector over cooperatives would then be somewhat on the lines of control that Registrar of Companies has over the Banking Institutions, registered under the Companies Act.
A legal framework that clearly defines the rights and liabilities of parties to contracts and provides for speedy resolution of disputes was found to be essential for financial intermediation. The evolution of the legal framework has not kept pace with the changing commercial practices and with the financial sector reforms. The Transfer of Property Act enacted in 1882 is a case in point.
Given the unsatisfactory state of the law of mortgage, the response had been to vest through special statute the power of sale in certain institutions like Land Development Banks and State Finance Corporations. This approach could be extended to other financial institutions and, if possible, to banks. The other approach was to set up special tribunals for recovery of dues to banks and financial institutions. These Tribunals neeeded to have powers of attachment before judgement, for appointment of receivers and for ordering preservation of property. For this purpose, an amendment to the concerned legislation was found to be necessary. The Committee emphasised the importance of having in place a dedicated and effective machinery for debt recovery for banks and financial institutions.
Securitisation of mortgages was also critically dependent on the ease of enforcement and the costs associated with transfer of mortgages. The power of sale without judicial intervention was not available to any class of mortgages except where the mortgages was the Government or the mortgage agreement so provided and the mortgaged property was situated in Mumbai, Chennai and Calcutta and other towns so notified. Even if the power of sale without judicial intervention were available there would need to be measure to put the buyer in possession.
The question of stamp duties and registration fees also required review. There was a case for reducing stamp duties and registration fees substantially.
In view of the amendments to Section 28 of Indian Contract Act, banks expressed a fear that they could no longer limit their liabilities under bank guarantees to a specified period and that they would have to carry such guarantee commitments for long periods as outstanding obligations. Government departments do not generally return the original guarantee papers even after the purpose is served. This whole issue needed to be re-examined and bank guarantees exempted from the purview of the recent amendment to Section 28 of the Indian Contract Act. The issue of enforcing securities in the form of book debts also required review. The Committee also agreed with the proposal to amend the Sick Industrial Companies Act, seeking to trigger off the remedial mechanism on the sight of incipient sickness.
Certain legislative requirements would also be needed to implement some of the Committee's recommendations regarding the structure of the banking system and matters pertaining to regulation and supervision. The Banking Regulation Act was structured on the premise that bank supervision is essentially a Government function and that the Reserve Bank of India’s position was somewhat on the lines of an agent. The Act also provided appellate powers to Government over the decisions of the RBI in this regard. It also provided original powers in certain instances. The Committee felt that these provisions should be reviewed.
With respect to recommendations regarding constitution of a Board for Financial Regulation and Supervision, it would be necessary for amendments in the Banking Regulation Act and Reserve Bank of India Act. Amendments would also be needed in the Bank Nationalisation Acts to enable grant of greater managerial autonomy to public sector banks for lowering the minimum requirements of 51% Government ownership and as regards the constitution of Boards of Directors and of the Management Committees. The provisions relating to prior approval of Government for regulations framed under the Act would also need to be reviewed. In line with the above, amendments would also be needed in the State Bank of India Act with regard to shareholding of the RBI and constitution of its Central Board.
The suggestions put forward by the Committee were not exhaustive and they recommended that the legal implications with reference to each of the recommendations be examined and detailed legislative steps identified by the Ministry of Finance, Banking Division in consultation with the Ministry of Law. In view or the wide-ranging changes needed in the legal framework the Committee recommended setting up of an expert Committee comprising among others, representatives from the Ministry of Law, Banking Division, Ministry of Finance, RBI and some outside experts to formulate specific legislative proposals to give effect to the suggestions made above. Accordingly, the government constituted an Expert Legal Group under the Chairmanship of Shri. T.R. Andhyarujina, former Solicitor General.
The recommendations of the Committee were being implemented by the government. While some of the recommendations like, providing autonomy to banks to decide salaries and perquisites of employees according to individual bank’s profitability, length of service of chief executive officers for public sector banks, autonomy in matters relating to business operations, raising capital from the market by public sector banks, bringing down the government’s stake in nationalized banks etc. could be implemented, some other recommendations required legal enactment in the parliament to amend the provisions of the existing enactments. The government is determined to go ahead with the reform process and more liberalization is expected as far as banking system is concerned.
[1] Committee on Banking Reforms (Narasimham Committee II), Action Taken Report dated October 31,2001, Reserve Bank of India.
[2] ibid