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
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
