6.  Payments and Settlement System

1.80  The functioning of the payments and settlement system has a crucial bearing on the efficiency of money, capital and forex market and has manifold implications for the conduct of monetary policy. A number of initiatives were taken in 1997-98 to enlarge the coverage of payment systems. Mention may be made of increased utilisation of electronic clearing of debit and credit items in many major cities. The work relating to the satellite-based Wide Area Network to provide reliable communication framework for the financial sector has progressed and is  expected to be operational before the end of 1998-99. The upgradation of the Cheque Clearing in the banking industry and the existing cheque processing systems at the four National Clearing Centres (NCC) has been taken up. The Year 2000 problem is being proactively dealt with by the Reserve Bank in coordination with IBA, banks and other sectors of the financial system.

*  Revised to Rs.41,661 crore.      P : Provisional.

Note : Figures in brackets are percentages to the total.

* Out of 36 foreign banks, 16 banks had nil NPA as compared with 12 (out of 30) in 1995-96.

@ Out of 34 foreign banks 14 banks had nil NPA.

7.  Overlapping functions of Banks and Financial Institutions

1.81  In recent years,  there is an increasing convergence in the asset-liability structure of banks and financial institutions. With the drying up of concessional Long-Term Operations (LTO) funds from the Reserve Bank in the early 1990s, FIs have increasingly raised resources at the short end of the deposit market. Besides, they have entered increasingly into working capital financing, and short term financing.  Commercial banks, on their part, have increasingly moved to term lending paving way for universal banking.  The Working Group on Harmonising the Roles of Banks and Financial Institutions (Chairman: Shri S.H.Khan), in its report submitted in April 1998, made certain recommendations for strengthening the organisation of domestic institutions/banks which inter alia include, (i) a gradual move towards universal banking and evolving an enabling regulatory framework for this purpose; (ii) exploring the possibility of gainful mergers between different sets of financial entities (banks /FIs) based on commercial considerations; (iii) speedy implementation of legal reforms to expedite debt recovery; (iv) consolidated supervision of banks and FIs; (v) reducing CRR to internationally acceptable levels; and (vi)  phasing out SLR.  The Monetary and Credit Policy for the first half of 1998-99 has proposed to prepare a Discussion Paper' which would contain the Reserve Bank's draft proposals for  bringing greater clarity in the respective roles of banks and financial institutions and for greater harmonisation of facilities and obligations applicable to them, taking into account the recommendations of the Narasimham Committee Report (1998) which have a bearing on the issues considered by the Working Group.

8.  Rural Credit and Credit to Small Scale Industries (SSIs)

Rural Credit

1.82  Rural sector financing continued to be a major policy concern during 1997-98.  The refinancing capacity of the National Bank for Agriculture and Rural Development (NABARD) was further enhanced by  increasing (a) its capital base and (b) the General Line of Credit Limit.  The General Line of Credit Limit from the Reserve Bank was increased from Rs.5,500 crore in 1996-97 to Rs. 5,700 crore during 1997-98. The share capital of the NABARD was increased from Rs.1,000 crore during 1996-97 to Rs.1,500 crore by 1997-98.

1.83  The policy to channelise shortfall in priority sector lending by banks into rural infrastructure investment continued during 1997-98 also.  Apart from the RIDF III corpus of Rs. 2,500 crore, the Union Budget 1998-99 has announced the establishment of RIDF-IV with a corpus of Rs.3,000 crore. In order to strengthen the capital base of rural institutions, a sum of Rs.400 crore was released by Government of India for recapitalisation of 90 RRBs in 1997-98 of which 15 were included for the first time. The Union Budget 1998-99 has earmarked an amount of Rs.265 crore for further recapitalisation of RRBs.

Action taken on Gupta Committee Report

1.84  The one man committee under the Chairmanship of Shri R.V. Gupta which examined the problems faced by the borrowers in agricultural sector, had made several recommendations for ameliorating the problems in the flow of agricultural credit. The recommendations relating to several procedural modifications on agricultural credit have been advised to banks for implementation.  These recommendations cover greater flexibility and discretion to the lending banks in matters of collateral, margin, security, dispensing with no dues certificates, introduction of a composite cash credit limits to cover farmers' production, post-harvest and household requirements, etc.  Besides, IBA has been requested to work out simplifying application forms for agricultural loans and banks have been advised to delegate sufficient powers to their branch managers.  Similarly, the recommendations which are to be considered by the Government like abolition of stamp duty for agricultural loans, assistance from State Governments for recovery of banks dues, matters relating to mortgage of land, banks finance to tenant farmers and also matters pertaining to subsidy-linked credit have been forwarded to the Government for necessary action.  The action taken by banks was reviewed at a meeting of a select bankers on September 26, 1998.  Bankers reported that they have initated action for implementing the recommendations of the committee.

Credit to Small Scale Industries

1.85  The Small Scale Industries (SSI) account for nearly 40 per cent of the gross turnover of manufacturing sector, 45 per cent of manufacturing imports and 35 per cent of total exports from the country.  The limited accessibility of the SSI to institutional finance has been a major policy concern. A Committee  was set up by the Reserve Bank in December 1997 (under the Chairmanship of Shri S.L. Kapur) to suggest measures for improving the Credit Delivery System for SSIs. The Committee submitted its report in June 1998 and the major recommendations of the Committee are as follows:

1.86  The Committee has made totally 126 recommendations covering wide range of areas relating to financing of SSI sectors.  The Reserve Bank had examined these recommendations and decided to accept 35 recommendations for immediate implementation.  These recommendations cover delegation of more powers to branch managers, simplification of applications, opening more SSI specialised branches, enhancement in the limit for composite loans, strengthening of recovery mechanism, etc. The remaining recommendations are under examination in consultation with NABARD, SIDBI and Government of India.

9.  Perspectives

1.87  The improved performance of banks during 1997-98 essentially reflects the gains arising from financial sector reforms.  The successful meeting of capital adequacy requirements and reduction of the level of NPAs in particular are significant.  There has been clear evidence of prudent management of investment portfolios as reflected in their participation in primary auctions of Government securities, and in significant  interest income from Government securities.

1.88  The agenda for further reforms was set out by the  Narasimham Committee Report (1998) which include further refinements of prudential norms and enhancement of capital base of banks.  The focus of further reforms has to be and has rightly been on improving efficiency and accountability and on further improving the functioning of financial markets.

Capital Adequacy Standards

1.89  In recent years, capital adequacy has been the cornerstone of prudential regulatory framework in India.  Most of the PSB except one, have already attained 8 per cent minimum risk weighted capital adequacy ratios . Most of the infusions of capital for PSBs (more than Rs.20,000 crore) had come from the  Government; a few banks raised capital from the  market (including one through GDR). Still as Narasimham Committee Report (1998) had pointed out, there is need for improving capital adequacy, in the light  of the significantly high "cost of servicing of the loans".

1.90   Taking into consideration the substantial off-balance sheet exposures of banks, the Narasimham Committee (1998) had recommended enhancement of capital adequacy ratio from the present stipulation of 8 per cent to 10 per cent by 2002. Endorsing this decison , the Union Budget, 1998-99  has announced raising of the minimum capital adequacy ratio to 9 percent by March 31, 2000 and to 10 percent as early as possible thereafter.  Viewed from the regulatory and supervisory point of view, it is important to note that enhancement of bank capital has to be based on each bank's assessment of its optimal level of capital given its risk exposure and should not be at the expense of shedding  loans.  It must be reiterated that there is nothing like zero risk lending and banks have to develop in-house expertise to manage risks effectively.  Moreover in a scenario where banks are increasing their non-traditional banking and off-balance sheet activities substantially, capital is the only resource available to banks to absorb any adverse effects on account of such activities.  Therefore, an increase in capital standards would be the right signal from supervisors to banking industry.

1.91 The recommendations of Narasimham Committee needs to be seen in the context of an emerging view that Basle capital adequacy accord is no longer adequate and needs to be modified.  The Basle Accord, it needs to be recognised, sets a minimum capital ratio, not a maximum insolvency probability and also is not a static framework, but is developed and improved continuously, as is evident from the January 1996 Amendment to introduce capital charges to market risk⁵. In this context, the recommendation of Narasimham Committee Report for recording a 5 per cent weight to investment in Government and approved securities requires to be examined.

Transparency

1.92  One of the important reasons for the recent turmoil in South East Asia is the absence of proper disclosures in the balance sheets of financial intermediaries.  The transparency of the banking and financial system is an issue related to sound financial infrastructure (See Box I.2).  In fact, the lack of transparency results in incentive to evergreen' loans, thereby impacting on the performance of assets.

1.93  A major element of the financial sector reforms in India has been the application of prudential norms and regulations introduced in 1992 aimed at ensuring safety and soundness of the financial system and at the same time encouraging markets to play increasing role.  Prudential norms serve two primary purposes - first they reveal the true position of the bank's loan portfolio and secondly, they help arrest its deterioration.  Prudential reforms introduced in India relate to income recognition, asset classification and provisioning for bad and doubtful debts and capital adequacy.  Over a period of time, these measures have been tightened.  For example, an account was considered non-performing in 1992-93 if its principal and interest was due for four quarters; this was reduced to two quarters by 1994-95.  The disinvestment of shareholding of PSBs has also facilitated availability of further information about their functioning through quarterly financial results.  These measures for ensuring greater transparency in operations of banks in India are vital for smooth functioning of financial markets.  Transparency and availability of timely information facilitate markets to form their own expectations in a more rational and realistic manner.

     Banking operations worldwide have undergone phenomenal expansion in the last two decades. Financial liberalisation and technical change have created new and complex financial products and have increased their turnover in financial markets. Although the benefits of these developments have been substantial, they have also created more risks. The banking crisis episodes in Latin America and South-East Asia are testimony to this. This brought to the fore, the core issue of whether there is a need to closely monitor banking/financial institutions and the existing disclosure and transparency of information by banks are sufficient enough for various interested groups (including its depositors and shareholders) to judge these entities. It is increasingly recognised that transparency would facilitate better monitoring of banks by depositors/shareholders.

     The growing globalisation of banks and the introduction of modern information technology by international banks have enabled the banks to rapidly expand their non-fund and off-balance sheet activities. Making the bank asset portfolio more transparent could help in the task of measuring capital and risks associated with banking transactions. Secondly, increased transparency could also facilitate market discipline - a highly desirable goal in our rapidly changing financial environment.  It has the potential to allow regulation and supervision to be less bothersome. Thirdly, disclosure and transparency enable markets to discipline banks to pursue healthy and sustainable policies via funding costs, credit lines and share prices. Lastly, public disclosure can limit contagion effect during market turmoil as sound banks can distinguish themselves from the weak ones.

     The financial accounting of banking operation and other qualitative information forming disclosure, vary from bank to bank and from country to country. Regarding transparency or public disclosure, there is the New Zealand model, which relies on market discipline and public disclosure.  On the other hand, there are other developed countries, which apart from prescribing certain public disclosures of financial aspects of banks, have also adopted on-site inspection of banks (besides off-site surveillance) to understand their financial soundness. Auditors play a major role in determining the disclosure and soundness of the banking system reflecting true and fair view of financial position of banks. In an environment of advanced information technology, internal auditors have to adopt a pro-active stance in keeping the internal control systems in order, by ensuring higher level of transparency of information. External auditors have to play an important role in disclosure which goes beyond the certification that the balance sheet and profit and loss accounts exhibit the true and fair' view of the affairs of the bank⁶.

     The Committee on the Financial System (Chairman Shri M.Narasimham) of 1992, and the Working Group to Review the System of On-Site Supervision over Banks (Chairman Shri S. Padmanabhan) of 1995 had recommended for proper strengthening of supervision of banks leading to sound and transparent banking system. In order to strengthen the internal control system for providing better guidance to banks, the Jilani Committee Report on Internal Control Systems provided the necessary input to set the house in order. However, in ensuring overall soundness of the banking system, the critical role of external auditors who has to express an opinion on the financial results viz., balance sheet and profit and loss account should not be underestimated. With the total report on the financial statements, they submit a report called Long Form Audit Report (LFAR) for banks. This report normally contains the opinion of the auditors on balance sheet, adequacy of information for the purpose of audit, whether profit and loss account indicates true and fair view of the accounts, etc.  They have also been asked to be a part of statutory audit to verify compliance with SLR requirements. If the financial statements consisting of accounting and disclosure practices do not project the true state of affairs of banks, banking supervisors will have to impress upon the banks to devise methods for making their operational details transparent on the lines of internationally accepted standards.

     In the context of the initiatives at the global level for greater transparency of financial intermediaries, a committee was set up by the Reserve Bank in March 1982 under the Chairmanship of Shri A. Ghosh for revising the format of presentation. The committee had revised and enlarged the formats of presentation of balance sheet and profit and loss accounts.  It had also prepared necessary guidelines for compiling the final accounts with a view to ensuring uniformity in the presentation of final accounts by different banks.  Furthermore banks were asked to give clarification notes in respect of the balance sheet and profit and loss items.

     As globalisation of banking increases the risk of contagion effect of banking problems, the need to ensure transparency has become vital for the regulators. In fact there is a need for sharing information about banks among regulators within the country and outside. On the disclosure side, as there is not much uniformity in practices in various countries, it has become difficult to distinguish healthy banks from unhealthy ones. Differences in accounting standards across countries and the absence of serious penalties for publishing inaccurate information also obstruct a meaningful assessment of banks.

     The Securities and Exchange Board of India (SEBI), as a regulatory institution for capital market activities, facilitates disclosure of information by all players in the market including banking intermediaries. This is primarily aimed at protecting the interests of investors in the first instance and for developing an efficient capital market system in the country. The SEBI, which came into being in 1992, issued guidelines on disclosure of information and investor protection for players in capital market. Some of the important disclosure requirements (to be published in the prospectus) of companies entering capital market include disclosure about past profit record of the company, details of contingent liabilities, pending cases against the company and cases associated with promoters of the company.

SELECTED REFERENCES

Karr, J. (1996) 'Line-of-Business Performance: 1995 Disclosures and Best Practices', Bank Accounting & Finance, 10, 36-42.

Falkenstein, E. (1997) 'Accounting for Economic and Regulatory Capital in RAROC Analysis', Bank Accounting & Finance, 11,  29-34.

Kane E.J. (1997) 'Making Bank Risk Shifting Move Transparent', Pacific-Basin Finance Journal  5, 143-156.

Reserve Bank of India (1985), Report of the Committee to consider Final Accounts of Banks (Chairman: Shri A. Ghosh).

Claudio, E.V. B and  Filosa, R. (1994), 'The Changing Borders of Banking: Trends and Implications', Bank for International Settlements, Basle.

Corrigan, G (1989) 'A Perspective on Recent Financial Disruptions', Federal Reserve Bank of New York Quarterly Review, 1989-90,14, 8-15.

Non-Performing Assets

1.94  The level of NPAs - both gross/net - of PSBs as a percentage to gross/net advances have been on decline.  The percentage of gross  NPAs to advances which was at 24.8 per cent in 1993-94 have come down to 16.0 per cent and in 1997-987.  However, the absolute magnitude of the level of gross NPAs at Rs.45,653 crore and net NPAs at Rs.21,232 crore  of PSBs in 1997-98 still remains a major hurdle, act as a deadweight loss for banks and has acted as an impediment to lower lending rates.  It is our endeavour that such deadweight losses are brought down substantially so that banks' balance  sheets are clean and they can start on a clean slate.

Asset Reconstruction Funds

1.95  Although the proposal for Asset Reconstruction Fund (ARF) was mooted by the Committee on Financial System (CFS) in 1991, it did not evoke much policy response at that time mainly due to the concerns of moral hazard' that it engenders.  Given the slow pace at which Debt Recovery Tribunals (DRTs) have performed due to legal and other structural factors, it is useful to try ARF at least in a limited way while minimising the problem of moral hazard.  It is in this context that the Union Budget for 1998-99 proposed the creation of Asset Reconstruction Companies (ARCs) which will take over the NPAs of the banks and swap them with special bonds.  An amount of Rs.400 crore was set out in the Budget and it is important these funds be used only for the capital of ARCs and not to bail out weak banks - directly or indirectly.  Beside the use of ARCs, it is necessary to strengthen the system of negotiated settlements between lenders and holders of NPAs to bring down the level of NPAs of  banks.  The crucial aspect of negotiated settlements is that they should be done in an efficient and transparent way.

Size and Issues of Merger

1.96 The increasing forays of banks into new areas (either departmentally or through subsidiaries) and the convergence in the nature of business operations of banks, FIs and NBFCs raise the issue of virtues of merger of banks. In fact Narasimham Committee Report  had advocated merger between banks and DFIs and NBFCs based on business specific complimentaries.  The issue of merger is related to the question of size - what constitute the optimum size of a financial intermediary in the emerging economic environment.  A narrow view of the concept of size is the expansion of size of balance sheets of banks.  But a broader view of this concept involve issues such as efficiency, competitive and strategic repositioning. In principle, merger and acquisition provide an opportunity for banks to share resources,reduce intermediation costs and expand delivery platforms, as also to improve chances for economies of scale to operate.

Banking Standards

1.97  In recent years, financial markets in Asia have been subject to considerable stress.  In view of the growing integration of markets across borders, it is imperative that domino effects are minimised by refining and upgrading the financial infrastructure including instruments such as accounting standards, income and provisioning norms and insolvency laws.  It is necessary to ensure that the standards attained are equivalent to international  best practices.

1.98  In India, NPAs are defined as an advance that has not been serviced, as a result of past dues' accumulating for 180 days and over. Narasimham Committee Report 1998 had recommended that we move towards international norm of one quarter of a year.  Although moving towards international best practices is desirable, it is necessary from the point of view of stability of the financial system to move in a gradual manner.  In this connection, it is necessary to recognise that in many respects the NPA norms in India are considerably tighter than the international best practices.  For example, it is customary to make a distinction between collateralised and non-collateralised NPA in most of the developed countries and accordingly for collateralised NPAs lower provisions are allowed.  In India, the concept of NPA does not allow such concessions and almost all advances are collateralised.  This implies that the prudential norms in India are tighter than some of the international best practices in a very substantive way, and the provisions made are beyond the requirement of prudence.

Risk Management

1.99  Risk management is emerging as an important area that financial entities will need to handle in view of the play of market forces in all financial markets and the need to reckon securities  for the market valuation.  Effective risk management can reduce the adverse effects of macro-economic instability on the soundness of the financial system.  Banks in the process of providing financial services assume various kind of financial risks viz., credit, interest rate, foreign exchange and liquidity risks.  To some extent these risks could be eliminated through sound business practices and the others through a combination of product design and pricing.  In the past, banks had concentrated solely on asset management with liquidity and profitability being regarded as two opposing considerations.  As a result, banks ended up distributing assets in such a way that, for given liquidity levels, the return was the maximum.  Consequent to the  liberalisation of domestic markets, the volatility in interest/exchange rates would be transmitted to the financial sector as a whole.  In order to proactively address the risks, banks have to undertake a comprehensive Asset Liability Management (ALM) strategy.  The Monetary and Credit Policy for the second half of 1997-98 emphasized the need for banks to put in place a comprehensive ALM system.  This encompasses a process of continuous management (in terms of planning, organizing and controlling) of asset and liability volumes, rates and yields and incorporating the maturities of assets and liabilities into consideration as well.  Management of assets and liabilities requires gathering of enormous amount of information, market research and quick empirical reports to enhance the Management Information Systems (MIS).

1.100  Pricing of risk is an important area, requiring prime attention.  Banks have to move away from the relatively unscientific practices of pricing risks based on perception of customers to more scientific practice based on technical assessment of the risks involved while ensuring transparency.  Embracing scientific risk management practices will not only improve banks' credit management processes and increase profits, but also enable them to nurture and develop mutually beneficial relationships with customers.  Pursuant to these objectives, detailed draft guidelines were circulated to SCBs (excluding RRBs) in September 1998.

1.101  In recent years, financing infrastructure has become a challenge to banks.  In view of the fact that financing of infrastructure involves large funds to be committed  for long periods of time, banks could face asset-liability mismatches.  In order to meet the financing requirements of infrastructure and other large investment projects, banks need to develop the necessary expertise.  Consequently, banks have to gear themselves to develop adequate expertise in risk management backed up, as indicated earlier, by a proper MIS.

Supervision

1.102  The experience of Asian crisis has reiterated the need for sound regulatory and supervisory system in the course of financial liberalisation.  The role of supervision is to promote financial market stability and minimise  systemic risk.  In this task, there is a broad consensus that for markets  to operate in a fair, transparent and efficient manner, the financial sector reforms should proceed in an orderly fashion. The Narasimham Committee Report (1998) while laying down the signposts for second phase of banking sector reforms in India, suggested that the supervisory responsibility would need to guide the banking system in the charted path so as to achieve the desired goals.  The key elements of this strategy include (a) sound capital adequacy standards, (b) market discipline, and (c) a dynamic risk-focussed approach to  supervision. The cornerstone of bank supervisory processes is the promotion of prudent practices.

1.103  The supervisory strategy in India at present comprises both off-site surveillance and on-site inspections.  A detailed off-site surveillance system based on prudential' supervisory reporting framework on a quarterly basis covering capital adequacy, asset quality, loan concentration, operational results and connected lending has been made operational.  This is combined with a verification of prudent practices and financial condition of banks through on-site examination.  In regard to on-site inspection, the focus is now on the evaluation of total operations and performance of the banks under the CAMELS system, i.e. capital adequacy, asset quality, management, earnings, liquidity and internal control systems.  The new approach to annual financial inspections based on CAMELS framework commenced from July 1997. The main endeavour of this system is to detect problems before they manifest themselves. An efficient result-oriented on-site inspection system requires an efficient follow-up.  The entire cycle of inspection and follow-up action are  now completed within a maximum period of twelve months.  Monitorable action plan for rectification of irregularities/deficiencies noticed during the inspection within a time frame is drawn up and progress in implementation pursued with the concerned bank.  Thus the present supervisory system is a substantial improvement over the earlier system in terms of frequency, coverage and focus as also the tools employed. Nearly one-half of the Basle  Core Principles for Effective Banking Supervision has already been adhered to and the remaining are at different stages of implementation (Box I.3).

     The Basle Committee on Banking Supervision, in April 1997, released the Basle Core Principles for Effective Banking Supervision,  a set of twenty-five basic Principles which it advocates for a supervisory system to be effective.  The Basle Core Principles have been drawn up by the Basle Committee in close consultation with the supervisory authorities in fifteen emerging market countries⁸. The 25 Core Principles represent the basic elements of an effective supervisory system and cover pre-conditions for effective banking supervision, licensing and structure, prudential regulations and requirements, methods of ongoing banking supervision, information requirements, formal powers of supervisors and cross-border banking.  These principles are in the nature of minimum requirements and can be broadly categorised as :

Principle 1- Preconditions for effective banking supervision

Principles 2 to 5 - Licensing and Structure

Principles 6 to 15 - Prudential regulations and requirements

Principles 16 to 20 - Methods of ongoing banking supervision

Principle 21- Information requirements

Principle 22 - Formal powers of supervisors

Principle 23 to 25 - Cross-border banking

     The Basle Core Principles are intended to serve as a basic reference for supervisory and other public authorities worldwide to apply in the supervision of all the banks within their jurisdictions. The Principles are minimum requirements and in many cases may have to be supplemented by other measures designed to address particular conditions and risks in the financial systems of individual countries. The Principles have been designed to be verifiable by supervisors, regional supervisory groups, and the market at large. The twenty-five Core Principles are set out below.

Preconditions for Effective Banking Supervision

Licensing and Structure

Prudential Regulations and Requirements

Methods of Ongoing Banking Supervision

Information Requirements

Formal Powers of Supervisors

Cross-border Banking

     The South-East Asian Crisis has revealed the necessity of adequate and effective supervision of financial intermediaries in the course of financial sector reforms.  It is increasingly recognised that the implementation of these 25 core principles would have certainly lessened the severity and cost of the South - East Asian crisis.

     The Bank for International Settlements (BIS) endorse the twenty-five core principles for adoption by all countries. India has been an active member which participated in the original drafting of the Core Principles.  Thirteen of the twenty-five core principles of Banking Supervision have already been covered on the basis of legal provision enshrined in the Banking Regulation Act, RBI Act and/or executive instructions issued by the Reserve Bank.  In regard to the remaining twelve core principles, there is a need to take certain steps which will include amendments in legal provisions and establishing mechanism for cooperation among Regulators to comply with those principles.  Broadly, these relate to prescribing prudential requirements for additional capital charge for market risk, framing guidelines for addressing country and currency risk, need for assessing the sources and quality of Start up Capital, Supervisory Cooperation with Regulators inside and outside the country and consolidated supervision of institutions and their subsidiaries as conglomerates.   It may be mentioned that the additional capital charges for market risk has already been partially introduced by way of stipulation of earmarking of 5 per cent  of Tier I Capital for open position in foreign exchange and gold.  The Reserve Bank has recently issued guidelines on Asset-Liability Management which will be a step towards introduction of comprehensive Risk Management Systems in the banks. In respect of (i) Risk Management, (ii) Consolidated Supervision, (iii) Inter-agency Cooperation and (iv) Cross-border Supervision, steps are being taken for in-depth examination by groups internally created to identify specific actions needed for the purposes on hand.

1.104  The new regulatory framework introduced for NBFCs in January 1998 has sought to protect the interests of depositors and provide effective supervision over the NBFCs.  The major thrust of this new framework is an implementation of prudential norms like liquidity ratios, in respect of these registered NBFCs having regulated deposits in their books.  Compulsory registration of companies with the Reserve Bank has helped to give a fair idea of the magnitude of the problems involved in regard to inspection of NBFCs.

1.105  An area which has to be in the forefront in the second phase of financial sector reforms is in the arena of customer service.  In India, the major component of intermediation cost, especially in public sector banks has been the wage bill, and the cost component on account of Information and Technology (IT) has been limited.  It is the IT component which is crucial to customer service, given the large number of deposit accounts and the magnitude of debits and credits to these accounts.  It is necessary that banks adopt new IT strategies to reduce the transaction time and costs so as to improve banking service and efficiency.

Universal Banking

1.106  The emerging scenario in the Indian banking system points to the likelihood of provision of multifarious financial services under one roof.  This will present opportunities to banks to explore territories in the field of credit/debit cards, mortgage financing, infrastructure lending, asset securitisation, leasing, factoring, etc.  At the same time, it will throw challenges in the form of increased competition and place strain on the profit margins of banks.  Again, this brings into fore issues such as the mergers, capital adequacy, and risk management of banks.

1.107  The Khan Working Group (1998) had suggested a gradual move towards universal banking.  In the light of the recommendations of the Group, the Reserve Bank, in consultation with the Government of India, has proposed to prepare a Discussion Paper.  The paper will contain the Reserve Bank's draft proposals for bringing greater clarity in the respective roles of banks and financial institutions and  for greater harmonization of facilities and obligations applicable to them.

Harmonisation of the Role of Banks and DFIs

1.108  The reforms of the financial sector ushered in significant changes in the operating environment of banks and Development Financial Institutions (DFIs).  The deregulation of interest rates, disintermediation and increasing participation by banks in project finance significantly altered the operating environment of banks.  With DFIs, in turn, making forays into the realm of working capital or short term financing, the traditional operational divide between banks and DFIs is being increasingly blurred.  In the light of these developments, the Khan Working Group (1998) has advocated harmonising the role and operations of DFIs and banks.

1.109  As part of the process of harmonisation' of the role and operations of Banks and DFIs, the Khan Working Group envisaged the need to provide a greater degree of manoeuverability and a level-playing field in resource mobilisation.  One of the most significant strategic challenges facing DFIs is the ability to raise low-cost funds.  Till 1991, DFIs had access to low cost LTO funds from the Reserve Bank.  However, the drying up of low cost sources of funds has had two effects on the functioning of DFIs.  First, DFIs have been forced to go in both domestic and international markets, for raising resources at market-determined interest rates. Secondly, they started  competing for the same segments of business as banks namely the households.  Consequently, their margins have been under pressure.  Such squeeze on margins would necessitate a pro-active focus on portfolio quality and cost management.  The comparative advantage and/or disadvantage of DFIs vis-à-vis banks in this regard depends, to a large extent, on the quality of their portfolios, the accounting policies that are practiced and personnel management.  The banks, on the other hand, have a competitive edge in resource mobilisation through the route of retail deposits.  However, there would now be greater competition for funds with the entry of private banks, non-banking financial institutions, and mutual funds.

1.110  There are certain regulatory issues also that need to be addressed to make harmonisation successful.  First, banks are subject to CRR stipulation on their liabilities.  DFIs, on the other hand, face no such pre-emptions on their funds.  Secondly, although instrument-specific restrictions on resource mobilisation by DFIs by way of term deposits, term-money borrowings, CDs as also inter-corporate deposits have been replaced with umbrella limits, DFIs do not enjoy the advantage of branch network for resource mobilisation.  This, in effect, curtails DFIs' ability to raise low-cost deposits.  Thirdly, with the larger part of new loans going to capital-intensive projects like power, telecom etc., the DFIs would need to extend loans with longer maturities.  On the other hand, due to interest rate uncertainties, DFIs are finding it attractive to raise more of short-term resources.  Due to their past borrowings of long-term nature, the mismatch is still in their favour.  This, however, raises a challenge for the DFIs to manage the maturity match of their assets and liabilities on an on-going basis.

Year 2000 Compliance

1.111  In India, as in any other country in the world, banks are confronted with the Year 2000 problem9.  If measures are not taken to address the problem, normal operations of financial institutions will be disrupted, which would lead to disturbances in payment and settlement systems nationwide, the effects of which may spread to other sectors. In recent times, it has been increasingly recognised that the Year 2000 (Y2K) issue has cross-border implications.  Recognising this dimension, the Basle Committee on Banking Supervision has advised bank supervisors to consider aspects such as (i) Foreign activities of domestic banks, including the readiness of foreign markets and infrastructures, and (ii) Domestic activities of foreign banks, including the quality of head office preparedness and the readiness of the local branch or subsidiary to conduct business, typically within the domestic market.

1.112  In India, a high level Working Group with members drawn from banking, regulatory, supervisory and information technology departments in the Reserve Bank, representatives of IBA, commercial banks and NIBM has been constituted.  The Working Group reviews the progress by banks, their subsidiaries and financial institutions every month.  The banks have to also indicate to the Reserve Bank/IBA about the steps taken to ensure that their customers are Y2K compliant.  The banks have been advised to step up their efforts to assess, convert and thoroughly validate all systems and applications by September 30, 1998. They are also advised to validate interfaces/linkages with customers/ correspondents. Commencing October 1, 1998 the banks have been advised to continuously validate their renovated systems though testing and to identify alternative approaches if need be. Testing is required to be done with reference to critical dates relevant for Year 2000 testing.  Similar monitoring and compliance has to be ensured by non-banking subsidiaries of commercial banks, financial institutions, co-operative banks, regional rural banks and non-banking financial companies. Each bank has been advised to constitute an internal Core Group and the progress is to be monitored regularly by their top management and their boards.  Indian Banks Association is also conducting periodic reviews for the Y2K problem for the industry and coordinating with infrastructure agencies, trade bodies, etc.  A public awareness campaign has been initiated by the Indian Banks' Association (IBA) by inserting an advertisement in various newspapers highlighting the millennium problem and the need to resolve it well in time.  About 44 of 104 targetted commercial banks, and 12 of 41 non-banking subsidiaries of commercial banks are expected to be Y2K compliant by September 30, 1998.  The majority of remaining banks will achieve the norm by December 1998.  About 50 per cent of the financial institutions are expected to be Y2K compliant by the end of 1998. It is proposed to adopt the following strategies for attaining the full compliance of year 2000  problem in the financial sector.