VI . FINANCIAL REGULATION AND SUPERVISION

The banking system in India remained largely unaffected by the financial crisis, while several banks and financial institutions in the advanced countries failed or had to be bailed out with large sovereign support. The financial soundness indicators for the banking system in India during 2008-09 showed stability and strength; every bank in the system remained above the minimum regulatory capital requirement. Stress test findings suggested the resilience of the financial system, in the face of the severe external contagion from the global financial crisis. As at end-March 2009, all Indian scheduled commercial banks had migrated to the simpler approaches available under the Basel II framework. Post-crisis changes that may be necessary to strengthen the regulatory and supervisory architecture would be based on the evolving international consensus as well as careful examination of their relevance to the India-specific context. The time schedule for implementation of advanced approaches under Basel II has been notified and an inter-disciplinary Financial Stability Unit has been set up to monitor and address systemic vulnerabilities.

VI.1 Indian banks and financial institutions exhibited resilience in the midst of a severe global financial crisis. Notwithstanding the growing financial integration and globalisation, the banking system in India had no direct exposure to the sub-prime assets that triggered the crisis in the advanced economies. The indirect exposure of banks in this regard was also insignificant. Much before the crisis started in the advanced economies, the Reserve Bank had taken a number of measures which contributed to strengthening the resilience in the Indian banking system. These included prudential regulations for limiting the exposure of the banking system to sensitive sectors and appropriately rebalancing the risk weights of different assets. Necessary provisioning norms were prescribed and there has been a sustained emphasis on CAMELS parameters for supervision of Indian banks and financial institutions. The Committee on Financial Sector Assessment undertook single-factor stress tests for end-September 2008, which revealed that the Indian banking system could withstand significant shocks arising from large potential changes in credit quality, interest rate and liquidity conditions. It was assessed that even under the worst case scenario, the capital to risk-weighted assets ratio (CRAR) of Indian banks would remain above the regulatory minimum. Notwithstanding the resilience of Indian banks and financial institutions to the international financial crisis, when the global economic crisis started to dampen the domestic growth prospects, the Reserve Bank had to take a number of policy measures aimed at preserving and promoting financial stability, while supporting faster economic recovery.

VI.2 The regulatory and supervisory initiatives taken by the Reserve Bank during 2008-09 with regard to banks and other financial institutions are presented in this Chapter. A distinguishing feature of the various policy initiatives to strengthen the banking system and thereby promote financial stability is that some of these initiatives were a part of the ongoing policy efforts and not a response to the sequence of events that led to the global financial crisis. In addition to prudential regulations, steps were taken to improve customer service, enhance supervision and strengthen the anti-money laundering measures in the banking sector.

VI.3 For UCBs, further regulatory measures were taken in order to reap the gains accruing from the path laid down by the vision document for the sector through the MoUs and the Task Force for UCBs arrangement. During 2008-09, the Reserve Bank continued its regulatory focus on systemically important non-deposit taking NBFCs. A spate of measures was taken to address the liquidity concerns arising for the sector in the wake of the international financial crisis.

Measures Taken Before the Global Crisis

VI.4 Regulation of non-banking entities is being progressively strengthened and the process had started before the onset of the global financial crisis. NBFCs owned by foreign banks and regulated by the Reserve Bank, were brought under the Group concept, to contain the regulatory arbitrage. An elaborate prudential framework was put in place for NBFCs-ND-SI. Consolidated supervision of banking groups was introduced in 2003 and has been constantly strengthened thereafter.

VI.5 To limit the growth of bank-led financial conglomerates (FCs), banks’ equity investment in individual financial subsidiaries has been limited to 10 per cent of paid-up capital and reserves of the bank and aggregate investment has been limited to 20 per cent of paid-up capital and reserves. Banks’ non-banking activities are also limited by law and any significant strategic equity investments by banks require the Reserve Bank’s prior approval.

VI.6 Prudential regulations have been consistently strengthened. Major steps taken include limits on capital market exposures of banks, prescription of 50 per cent margin for advances against shares, limits on lending and borrowing in call money market, limit on inter-bank liabilities and restrictions on investment in unlisted and unrated non-SLR securities. The provisioning requirements for sub-standard and doubtful assets have been progressively aligned with best international practices, diminution in fair value of restructured accounts is required to be provided for and net appreciation in trading and available for sale book is not permitted to be recognised. The dividend payout ratio in case of banks is not allowed to exceed 40 per cent and dividend can be paid only out of current year’s profit. Securitisation profits cannot be booked upfront to contain perverse incentives.

VI.7 In order to ensure higher quality of regulatory capital, existing capital adequacy guidelines require that Tier I capital of banks should be at least 6 per cent of risk-weighted assets by March 31, 2010. Tier III capital for market risk has not been introduced, as it is short-term.

VI.8 Further, when there was very rapid credit growth from 2004-05 onwards, risk weights and provisioning for banks’ exposure to rapidly growing or sensitive sectors (such as commercial real estate, consumer loans and capital market), even when classified as standard assets, were progressively increased since 2005-06 as a counter-cyclical measure. Banks were also encouraged to maintain floating provisions which could be drawn down in extraordinary circumstances.

VI.9 To ensure adequate liquidity buffers with individual banks, banks were required to invest 25 per cent of their NDTL in government securities to maintain SLR (reduced to 24 per cent of NDTL in November 2008). The framework for monitoring and reporting of liquidity position of individual banks was improved by way of introduction of more granular liquidity buckets within the 1-14 segment (i.e., next day, 2-7 days, 8-14 days). Table 6.1 shows that Indian banking system continues to remain healthy.

Measures Taken During the Global Crisis

VI.10 The measures taken by the Reserve Bank during 2008-09 broadly include counter-cyclical moderation of capital and provisioning norms which had been enhanced earlier and provision of adequate rupee/foreign exchange liquidity to enable the banks to continue to lend for viable economic activities. The prudential measures are discussed in detail in subsequent paragraphs of this Chapter. The measures relating to liquidity and credit delivery are discussed in relevant Chapters.

REGULATORY FRAMEWORK FOR THE INDIAN FINANCIAL SYSTEM

VI.11 In the overall architecture for the regulation and supervision of the financial system in India, the Reserve Bank’s regulatory and supervisory purview extends to a large segment of financial institutions, including commercial banks, co­operative banks, non-banking financial institutions and various financial markets. At end-March 2009, there were 80¹ commercial banks (excluding RRBs); 4 local area banks; 86 RRBs; 1,721 UCBs; 4 development finance institutions; 12,739 NBFCs (of which 336 NBFCs were permitted to accept/hold public deposits) and 18² primary dealers (PDs) [of which 11 were banks undertaking PD business as a departmental activity, known as bank-PDs, and 7 were non-bank entities, also referred to as stand­alone PDs]. The Board for Financial Supervision (BFS) has been mandated to ensure integrated oversight over the financial institutions that are under the purview of the Reserve Bank.

Board for Financial Supervision (BFS)

VI.12 The BFS, constituted in November 1994, remains the principal guiding force behind the Reserve Bank’s supervisory and regulatory initiatives. It reviews the inspection findings in respect of commercial banks/UCBs and periodic reports on critical areas of functioning of banks such as reconciliation of accounts, fraud monitoring, overseas operations and banks under monthly monitoring. In addition, the BFS also reviews the micro and macro prudential indicators, banking outlook and interest rate sensitivity analysis. It also issues a number of directions with a view to strengthening the overall functioning of individual banks and the banking system. The BFS held eight meetings during the period July 2008 to June 2009. In these meetings, it considered, inter alia, the performance and the financial position of banks and financial institutions during 2008-09. It reviewed 70 inspection reports (27 of public sector banks, 16 of private sector banks, 20 of foreign banks, 4 of local area banks and 3 of financial institutions). Some of the important issues deliberated upon by the BFS during 2008-09 are highlighted in this section.

VI.13 In the wake of the global financial crisis, the BFS was apprised of the exposure of Indian banks to tainted assets and also the safeguards available within the Indian banking system on account of the regulatory measures initiated to strengthen the risk management and liquidity management systems of banks. The BFS was informed that an in-depth examination of investment portfolio of banks was being done as part of the Annual Financial Inspection (AFI). The BFS also enhanced its focus on monitoring the mark-to-market (MTM) losses in credit derivatives and other investment portfolios of overseas operations of banks in India on a monthly basis (Box VI.1).

VI.14 In response to concerns in some quarters regarding risks associated with foreign exchange derivatives, detailed information was called for in structured formats by the Reserve Bank from certain select banks which were operating at the top-end of the system-level exposures. Based on a dialogue process with these banks regarding, inter alia, the ‘suitability and appropriateness’ principles and risk management policies, a comprehensive report was placed before the BFS. In this context, stress tests of the credit portfolio of commercial banks in India were also carried out to assess the resilience of banks under various stress scenarios such as increasing the NPA level and provisioning requirements for standard, sub-standard and doubtful assets as at end-March 2008. The analysis was carried out at the aggregate and individual bank level and the results indicated that the CRAR would not decline below the stipulated minimum level under any of the adopted scenarios.

Box VI.1
Global Financial Crisis and the Indian Banking System: An Assessment of MTM Losses

Falling asset prices in the international markets exerted severe stress on the balance sheets of many international banks, on account of their significant exposure to such assets. Large off-balance sheet exposures magnified their stress levels further. In this context, it was felt necessary by the Reserve Bank to keep track of the quality of exposures of overseas operations of Indian banks for timely action and super visor y intervention, if required. Consequently, the Reserve Bank held discussions with select major banks with overseas operations to assess the quality of their overseas exposures. The assessment revealed that the banks did not have any direct exposure to the US sub-prime market. Some banks, however, had indirect exposure through their overseas branches and subsidiaries to the US sub-prime markets in the form of structured products, such as collateralised debt obligations (CDOs) and other investments. Some of the banks, with exposures to credit derivatives, had to book MTM losses on account of widening of credit default swap (CDS) spreads. The assessment, however, showed that such exposures were not very significant, and banks had made adequate provisions to meet the MTM losses on such exposures. Besides, the banks also maintained high levels of capital adequacy ratio. The Reserve Bank’s assessment suggested that, the risks to the banking sector associated with MTM losses, appeared to be limited and manageable.

As the financial crisis persisted and started spreading beyond the US, a need was felt to continuously monitor the exposures of the overseas operations of the Indian banks to detect adverse signals impacting the quality of the banks’ overseas exposures. Accordingly, a monthly reporting system was introduced in September 2007 capturing Indian banks’ overseas exposure to credit derivatives and investments such as Asset Backed Commercial Papers (ABCP) and Mortgage Backed Securities (MBS). An analysis of the information so collected reveals that the exposures of Indian banks through their overseas branches in credit derivatives and other investments are gradually coming down from the June 2008 level (Chart). Their MTM losses, however, gradually increased up to March 2009, reflecting the impact of the sustained fall in the value of the assets in their portfolios.

After the direct impact of the global financial crisis through MTM losses was assessed to be insignificant for Indian banks, the focus shifted to the possible asset quality concerns arising from weakening growth prospects as certain sectors in the economy clearly came under the influence of falling external demand due to the global recession and subsequent deceleration in domestic private demand. The asset quality of banks’ exposures to the sectors perceived to be under stress became a matter of supervisory concern. A credit risk stress test of banks’ exposure to seven such sectors (chemicals/dyes/paints etc., leather and leather products, gems and jewellery, construction, automobiles, iron and steel and textiles), accounting for 15.4 per cent of gross advances and 12.2 per cent of gross NPAs, was carried out to assess the impact on banks’ capital adequacy due to an assumed rise in NPAs. The stress tests were run under two scenarios, viz., 300 per cent and 400 per cent increases in NPAs in the seven sectors simultaneously. The additional provisioning requirements, assuming the rise in NPAs were adjusted from existing regulatory capital and risk-weighted assets, were estimated to arrive at the adjusted capital adequacy. The results of the stress tests revealed the inherent strength of the banks to withstand sizeable deterioration in asset quality in the identified sectors. The capital adequacy ratio of only two banks accounting for around 3 per cent of total assets of the banking system was assessed to drop below the prescribed minimum level under both the stress scenarios.

The assessment of MTM losses and stress test results, thus, further validated the resilience of the Indian banking system to the shocks and concerns emanating from the global economic crisis.

VI.15 During the period under reference, the BFS issued several directions for enhancing the quality of regulation and supervision of financial institutions and some of the important directions were as follows: (i) need for evaluation by the Reserve Bank, for robustness and efficacy, of the statistical scoring and loss forecasting models deployed by banks for managing retail credit portfolios; (ii) fine-tuning and making more dynamic the process for selection of branches for the AFIs, by including additional parameters for branch-selection; (iii) prohibiting subsidiaries of banks from undertaking activities which the bank itself was not permitted to undertake as per the provisions of the Banking Regulation Act, 1949; (iv) submission of confirmation report and compliance certificate with regard to adherence to the Reserve Bank's guidelines on outsourcing arrangements entered into by banks; (v) sensitising the banks that the principles for sale/purchase of NPAs, issued in October 2007, were laid down as a broad criteria only to be adopted while entering into compromise settlements and not meant to be rigid or restrictive (hence, banks could enter into these settlements based on the circumstances/facts of each case and their commercial judgement and should be able to justify the decision taken); and (vi) recording of intent of holding the investments, for a temporary period or otherwise, at the time of investment in a subsidiary, associate and joint venture, for the purpose of consolidation.

VI.16 The BFS also accorded its approval to certain important proposals aimed at enhancing the regulatory provisions/intent and supervisory focus. Some of them were as follows: (i) prescribing the extent of admissible liability towards Tier I and Tier II instruments in the scheme of merger/amalgamation of banks as and when such cases arose; (ii) a one-time measure designed to help banks to clear their large number of small value outstanding nostro entries originated up to March 31, 2002 while concurrently directing the banks to concentrate on follow-up effort on the high value entries that were still outstanding and to leverage technology to avoid building up of unreconciled balances.

COMMITTEE ON FINANCIAL SECTOR ASSESSMENT

VI.17 The work on a comprehensive self-assessment of India’s financial sector, particularly focussing on stability assessment, stress testing and compliance with all financial standards and codes started in September 2006 by the Committee on Financial Sector Assessment (CFSA), chaired by Dr. Rakesh Mohan. Shri Ashok Chawla, Shri Ashok Jha and Dr. D. Subbarao as Secretary, Economic Affairs, Government of India, were the Co-Chairmen of the CFSA at different points of time. In March 2009, the Government and the Reserve Bank jointly released the Report of the CFSA (Box VI.2). The CFSA followed a forward-looking and holistic approach to self-assessment, based on three mutually reinforcing pillars – financial stability assessment and stress testing; legal, infrastructural and market development issues; and an assessment of the status of implementation of international financial standards and codes.

VI.18 Overall, the CFSA found that the Indian financial system was essentially sound and resilient, and that systemic stability was, by and large, robust. India was broadly compliant with most of the standards and codes, though gaps were noted in the timely implementation of bankruptcy proceedings. The CFSA also carried out single-factor stress tests for credit and market risks, liquidity ratio and scenario analyses. These tests showed that there were no significant vulnerabilities in the banking system. Though NPAs could rise during the current economic slowdown, given the strength of the banks’ balance sheets, the rise was not likely to pose any systemic risk.

VI.19 Since risk assessment is a continuous process and stress tests need to be conducted taking into account the macroeconomic linkages as also the second round effects and contagion risks, consequent to the announcement in the Annual Policy Statement for 2009-10, an inter­disciplinary Financial Stability Unit was set up to monitor and address systemic vulnerabilities.

Box VI.2
Major Recommendations of the Committee on Financial Sector Assessment (CFSA)

The CFSA presented its assessment of India’s financial sector along with a set of recommendations meant for the medium-term of about five years. The key assessments and recommendations under major heads are summarised below.

Sustainability of Macroeconomic Growth

India’s growth in the recent period was primarily contributed by high domestic demand, productivity, credit growth and high levels of savings and investment. In the wake of the crisis, India could face deceleration in its macroeconomic growth in the short-term; however, growth of 8.0 per cent was sustainable in the medium-term. India would need to focus on revival of growth in agriculture, address quick restoration of the fiscal reform path, continue financial sector consolidation/development and address the infrastructure deficit. While fuller capital account convertibility was desirable, it should be concomitant with macroeconomic and market developments.

Financial Institutions

Commercial Banks

The stress testing of the financial institutions revealed that banks were generally in a position to absorb significant shocks due to credit, liquidity and market risks, though there were some concerns relating to liquidity risk due to increasing illiquidity in banks’ balance sheets. There was, therefore, a need to strengthen liquidity management.

The CFSA highlighted risk management as a priority area and noted that the counter-cyclical prudential norms imposed by the Reserve Bank had paid dividends in recent times. It highlighted the growing requirement of appropriate accounting and disclosure norms, particularly with regard to derivatives transactions.

Co-operative Sector

While the financial position of UCBs had improved, stress tests conducted for this sector revealed that these entities would remain vulnerable to credit risk. The financial indicators of the rural co-operatives threw up some cause for concern. Noting the dual control over co-operatives and rural banks, the CFSA stressed the need for better governance in these institutions.

NBFCs

The CFSA noted that NBFCs were important players in financial markets with broadly satisfactory financials. Development of the corporate bond market could ease the funding constraints of this sector. Further strengthening of prudential regulations of NBFCs was also suggested.

Housing Finance Companies (HFCs)

The CFSA recommended that a National Housing Price Index and a Housing Starts Index were priorities for the growing and important segment of HFCs.

Insurance Sector

For further development of the insurance sector, the CFSA suggested, inter alia, that the supervisory powers of IRDA be improved and an effective policy for group-wide supervision be put in place.

Financial Markets

The CFSA recommended, inter alia, further improvements in infrastructure, risk management and transparency/ disclosure in equity, foreign exchange and government securities markets. On the issue of development of markets for credit derivatives and asset securitisation products, the Committee noted that it should be pursued in a gradual manner, by sequencing reforms and putting in place appropriate safeguards before introduction of such products.

Financial Infrastructure

Regulatory Structure

The CFSA felt that the existence of multiple regulators was consistent with the current stage of financial development in India, but stressed the need for further improvement in regulatory coordination. The Reserve Bank could, in the interest of financial stability, be armed with sufficient supervisory powers and monitoring functions in respect of financial conglomerates.

Liquidity Infrastructure

Systems and procedures should be developed for smoothing out volatility in liquidity and call money rates arising out of quarterly tax payments. The introduction of auction of Central Government surplus balances with the Reserve Bank in a non-collateralised manner could be considered, though with appropriate caution.

Payments and Settlement Infrastructure

The current low utilisation of the electronic payments infrastructure could be increased with the use of technology to make the facilities more accessible to customers, thereby optimising the use of this infrastructure and achieving greater financial inclusion.

Others

The Committee also discussed insolvency regime, corporate governance and safety nets, among others.

Development Issues in the Socio-economic Context

A stability assessment of the financial sector should also address broader development aspects in the socio-economic context, which affect social stability and have an indirect bearing on financial stability. Financial inclusion is one of the major determinants of economic growth. Higher economic growth and infrastructure, in turn, play a crucial role in promoting financial inclusion. In order to achieve the objective of growth with equity, it was imperative that infrastructure was developed in tandem with financial inclusion, to facilitate and enhance credit absorptive capacity.

COMMERCIAL BANKS

Operational Developments

VI.20 Indian banks continued to expand their presence overseas during 2008-09. Between July 2008 and June 2009, Indian banks opened 20 branches/subsidiaries/representative offices overseas (Table 6.2). At end-June 2009, 20 Indian banks (14 public sector banks and 6 private sector banks) had presence abroad with a network of 221 offices (141 branches, 52 representative offices, 7 joint ventures and 21 subsidiaries) in 52 countries. Several foreign banks opened branches and representative offices in India during 2008-09 (Table 6.3). At end-June 2009, 32 foreign banks were operating in India with 293 branches. Besides, 43 foreign banks were also operating in India through representative offices. There were 73 banks under liquidation all over India as on June 30, 2009. The matter regarding early completion of liquidation proceedings is being followed up with official/Court liquidators.

Regulatory Initiatives

VI.21 Policy measures taken by the Reserve Bank during 2008-09 were driven by the twin objectives of continued strengthening of the prudential standards for the banking system in order to make it more resilient and align these with the international best practices while ensuring customer protection, and deliver a counter-cyclical prudential prescription to complement the fiscal policy measures initiated by the Government to fight the downturn in the economy.

Basel II Implementation

VI.22 Foreign banks operating in India and Indian banks having operational presence outside India migrated to the simpler approaches available under the Basel II framework with effect from March 31, 2008. Other commercial banks (excluding local area banks and RRBs) also migrated to these approaches from March 31, 2009. Thus, the standardised approach for credit risk, basic indicator approach for operational risk and standardised duration approach for market risk (as slightly amended under the Basel II framework) have been implemented for banks in India. Taking into consideration the need for upgradation of risk management framework as also the capital efficiency likely to accrue to the banks by adoption of the advanced approaches envisaged under the Basel II framework and the emerging international trend in this regard, it was considered desirable to lay down a timeframe for implementation of the advanced approaches in India (Table 6.4). This would enable the banks to plan and prepare for their migration to the advanced approaches for credit risk and operational risk, as also for the internal models approach (IMA) for market risk.

VI.23 Banks were advised to undertake an internal assessment of their preparedness for migration to advanced approaches, in the light of the criteria envisaged in the Basel II document and take a decision, with the approval of their Boards, whether they would like to migrate to any of the advanced approaches. The banks deciding to migrate to the advanced approaches were advised to approach the Reserve Bank for necessary approvals, in due course, as per the stipulated time schedule. If the result of a bank’s internal assessment indicated that it was not in a position to apply for implementation of advanced approaches by the above-mentioned dates, it could choose a later date suitable to it based upon its preparation. Banks, at their discretion, would have the option of adopting the advanced approaches for one or more of the risk categories, as per their preparedness, while continuing with the simpler approaches for other risk categories, and it would not be necessary to adopt the advanced approaches for all the risk categories simultaneously. Banks would, however, need to acquire prior approval of the Reserve Bank for adopting any of the advanced approaches.

Risk Management

VI.24 In the wake of the current crisis, the risk management models based on normal distribution were found inadequate to cope with the rapidly changing events. It is widely believed that more robust risk management systems, grounded in appropriately designed stress tests, could have helped prevent the build-up of leverage that became unsustainable. Thus, there is an imperative need to strengthen the risk management systems/models by incorporating imaginative stress testing practices to avoid recurrence of such events and preserve national and global financial stability (Box VI.3).

NPA Management

VI.25 The three legal options available to banks for resolution of NPAs, viz., the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act, 2002), Debt Recovery Tribunals (DRTs) and Lok Adalats, have led to a steady increase in the adjudication and recovery of disputed amounts (Table 6.5).

Box VI.3
Risk Management: Role of Stress Testing

Stress testing is a multi-dimensional risk management tool with numerous and varied potential applications. It involves the use of a range of techniques, both quantitative and qualitative, to evaluate a bank’s financial position under exceptional but plausible scenarios of varying severity. Stress test findings could assist in forward looking decision making.

Globally, banks are increasingly relying on statistical models such as Value at Risk (VaR) for their risk management frameworks. These models are, however, based mainly on limited historical data and simplistic assumptions and therefore, cannot capture sudden, dramatic, high magnitude and long duration events. To overcome the limitations of risk management models, stress testing is being used as a supplementary tool to quantify “tail risks”, i.e., the risk of losses under abnormal market conditions and re-assess modeling assumptions, particularly those in relation to volatility and correlation. It is especially important after long periods of favourable economic and financial conditions, when fading memory of negative conditions could lead to complacency and neglect as well as under-pricing of risk. It is also a key risk management tool during periods of expansion, when innovations may lead to new products that could grow rapidly and for which limited or no loss data may be available.

Stress testing is useful in a bank’s risk management framework and decision making process on account of the following:

• It provides a means for estimating a bank’s risk exposures under stressed conditions and enables it to develop or choose appropriate strategies for mitigating such risks.

• It helps a bank in identifying hidden risks and risk concentrations across multiple business lines or units.

• It enables a bank to better shape its risk profile through a forward-looking assessment of the risks it may be exposed to and facilitates monitoring of changes in the profile over time.

• It allows the Board of Directors and senior management to determine whether a bank’s risk exposure or profile corresponds to its risk appetite and risk tolerance.

• It enables the bank management to integrate business strategy, risk management and liquidity and capital planning decisions in an improved way.

Considering the importance of stress testing in any risk management framework, the Basel Committee on Banking Supervision issued in May 2009 the paper titled “Principles for Sound Stress Testing Practices and Supervision”. The paper presents sound principles for the governance, design and implementation of stress testing programmes in banks. It says that stress testing should form an integral part of the overall risk governance and risk management culture of a bank. Stress testing should be actionable, with the results from stress testing analyses impacting decision making at the appropriate management level, including strategic business decisions of the Board and senior management. Board and senior management involvement in the stress testing programme is essential for its effective operation. A bank should operate a stress testing programme that promotes risk identification and control, provides a complementary risk perspective to other risk management tools, improves capital and liquidity management and enhances internal and external communication.

Though stress testing and scenario analysis play an important role in any risk management framework, they have certain limitations such as subjective selection of scenarios, skill of the modeler, uncertain probabilities of the events concerned and use of a small number of parameters. Stress testing, therefore, by itself cannot address all risk management weaknesses, but as part of a comprehensive approach, it has a useful role in aiding timely policy intervention to strengthen the resilience of individual banks and the financial system.

References

1. Basel Committee on Banking Supervision (2009). “Principles for Sound Stress Testing Practices and Supervision”, Bank for International Settlements, May 20.

2. Haldane A.G. (2009). “Why Banks Failed the Stress Test”, Bank of England (speech), February 13.

3. Duguay P. (2009). “Financial Stability through Sound Risk Management”, Bank of Canada (remarks), January 8.

Restructuring of Advances

VI.26 The guidelines on restructuring of advances were revised in August 2008 in accordance with the recommendations of the Working Group to review and align the existing guidelines on restructuring of advances [other than under corporate debt restructuring (CDR) mechanism] on the lines of provisions under the revised CDR mechanism. The main features of the guidelines, which are uniformly applicable across all sectors, are: (i) Retention of asset classification status on restructuring is an exception rather than a rule. It is, however, available to all borrowers who meet specified conditions, except to the borrowers of three categories, viz., consumer and personal advances, advances classified as capital market exposure and advances classified as commercial real estate exposures (subject to modifications carried out subsequently); (ii) The CDR mechanism would be available to the borrowers engaged in activities other than industrial advances as well, albeit subject to the same terms and conditions as applicable to industrial advances. There is no change in the institutional framework for restructuring under the CDR mechanism; (iii) The linkage of asset classification benefit with moratorium has been dispensed with considering certain natural checks built in the guidelines against extension of longer moratorium; (iv) Banks should make provision for diminution in the fair value of the loan (both principal and interest cash flows) rather than for economic loss arising from reduction in rate of interest alone, as done hitherto; a simpler mechanism to compute the diminution in fair value at a flat rate of 5 per cent would be available to borrowers with outstanding amounts below Rs.1 crore; (v) The unrealised income represented by the Funded Interest Term Loan (FITL)/debt or equity instrument should not be taken to the profit and loss account but credited into an account styled as ‘Sundry Liabilities Account (Interest Capitalisation)’ [SLA(IC)]. Only on repayment in case of FITL or sale/redemption proceeds of the debt/equity instruments, the amount received would be recognised in the profit and loss account, while simultaneously reducing the balance in the ‘SLA(IC)’; (vi) The terms – ‘satisfactory performance during the specified period of one year after restructuring’, ‘repeated restructuring’ and ‘secured advances’ were clarified; (vii) In the case of infrastructure projects, in order to become entitled for the asset classification benefit, the period within which the viability had to be established was increased from 7 years to 10 years, and the period within which the loan had to be repaid was increased from 10 years to 15 years. In the case of housing loans, individual banks, with the approval of their Boards, were permitted to decide on the repayment period required for restructured loans;

(viii) One of the conditions for availing special asset classification benefit in terms of guidelines on restructuring of advances is that the account should be fully secured. This condition would not be applicable in the case of infrastructure projects, provided the cash flows generated from these projects were adequate for repayment of the advance, the financing bank(s) had in place an appropriate mechanism to escrow the cash flows and also had a clear and legal first claim on these cash flows.

Credit Information Companies

VI.27 The Reserve Bank had invited applications from companies interested in continuing/ commencing business of credit information in April 2007 A High Level Advisory Committee (HLAC) under the Chairmanship of Dr. R.H. Patil was set up for screening the applications and recommending the names of the companies to which certificates of registration (CoRs) could be granted. The Government announced the FDI policy for credit information companies (CICs) in March 2008. The Reserve Bank announced in November 2008 that FDI up to 49 per cent in CICs would be considered in cases: (a) where the investor was a company with an established track record of running a credit information bureau in a well regulated environment; (b) no shareholder in the investor company held more than 10 per cent voting rights in that company; and (c) preferably, the company was a listed company on a recognised stock exchange. Keeping in view the provisions of the CICs (Regulation) Act, 2005 as well as the directives issued by the Reserve Bank, the HLAC had recommended the names of four applicants which the Reserve Bank could consider for granting CoRs. Accordingly, the Reserve Bank, in April 2009, issued ‘in-principle approval’ to four companies to set up CICs.

Approval for Offering Complex Financial Products

VI.28 Indian banks were advised in December 2008 that if their foreign branches/subsidiaries were transacting in any financial products, which were not available in the Indian market, but on which no specific prohibition was placed by the Reserve Bank, prior approval would not be required only if these were plain-vanilla financial products. The foreign branches/subsidiaries dealing with such products, however, must have adequate knowledge, understanding and risk management capability for handling such products. Such products were to be appropriately captured and reported in the extant off-site returns. Banks would have to obtain prior approval in case their foreign branches/subsidiaries proposed to handle such products.

Unhedged Foreign Exchange Exposure of Clients

VI.29 Banks had been advised in December 2003 to have a policy, which explicitly recognised and took into account risks arising on account of unhedged foreign exchange exposures of their clients. It was also advised that foreign currency loans above a specified limit could be extended only on the basis of a well laid out policy of banks’ Boards with regard to the hedging of such loans. It was further advised in December 2008 that the Board’s policy should cover unhedged foreign exchange exposure of all clients, including SMEs, which should take into account exposure from all sources, including ECBs. Banks were advised to monitor and review on a monthly basis the unhedged portion of the foreign currency exposures of clients with large foreign currency exposures and the unhedged exposure of SMEs. In all other cases, banks were advised to put in place a system to monitor and review such positions on a quarterly basis.

Counter-cyclical Prudential Norms

VI.30 Banks’ loans and advances portfolio often move pro-cyclically, growing faster during an expansionary phase and vice versa. During times of expansion and accelerated credit growth, there is a tendency to underestimate the level of inherent risk and the converse holds during times of recession. This tendency is not effectively addressed by capital adequacy and specific provisioning requirements since they capture risk ex-post, not ex-ante. It is, therefore, necessary to build up capital and provisioning buffers during a cyclical boom, which could be used to cushion banks’ balance sheets in the event of a downturn in the economy or deterioration in credit quality on account of other reasons. In order to ensure that asset quality was maintained in the light of high credit growth, risk weights and provisioning requirements on standard advances for banks’ exposures to the sectors showing above average growth had been progressively raised during the last 3-4 years, as a counter-cyclical measure. However, with the global financial crisis starting to affect Indian economy from September 2008 onwards, the Reserve Bank reduced the enhanced risk weights and provisioning requirements to the normal level.

VI.31 Risk weight for all unrated claims, long-term as well as short-term, regardless of the amount of claim, on the corporates was reduced from 150 per cent to 100 per cent in November 2008. Risk weight on the claims secured by commercial real estate and exposure to NBFCs-ND-SI was reduced to 100 per cent from 125 per cent.

VI.32 Prior to the unfolding of the global crisis, to ensure that asset quality was maintained in the light of high credit growth, the general provisioning requirement for standard advances in specific sectors, i.e., personal loans, capital market exposures and commercial real estate loans had been increased from 0.4 per cent to 2.0 per cent, and to 1.0 per cent for residential housing loans beyond Rs.20 lakh in January 2007. To mitigate the impact of the current economic slowdown, as a counter-cyclical measure, the provisioning requirement for standard assets was reduced with effect from November 15, 2008, to a uniform level of 0.4 per cent, except in the case of direct advances to the agricultural and the SME sectors, which continue to attract provisioning of 0.25 per cent. The revised norms were made effective prospectively and thus, the provisions already held were not to be reversed. Similar instructions were issued to UCBs.

VI.33 In December 2008, in view of the growing concern of possible increase in stress in the Indian banking system, certain modifications were made to the guidelines on restructuring of advances (issued in August 2008) as a one-time measure and for a limited period of time, i.e., up to June 30, 2009. The special regulatory treatment for asset classification (i.e., retention of the asset classification status of the account as obtaining at the time of restructuring), was extended to commercial real estate exposures restructured for the first time and in the case of exposures (other than commercial real estate, capital markets and personal/consumer loans), which were viable but were facing temporary cash flow problems and needed a second restructuring. Accounts which were standard as on September 1, 2008 but slipped into the NPA category subsequently, were treated as standard on restructuring provided banks took them up for restructuring on or before March 31, 2009 and the restructuring package was put in place within the prescribed quick implementation time schedule. The condition of full security cover for availing the special regulatory treatment was waived in case of cash credit accounts which had been rendered unsecured due to fall in inventory prices, subject to banks making provisions as prescribed. It was emphasised that the relaxations effected to the guidelines on restructuring of advances by the Reserve Bank were aimed at providing an opportunity to banks and borrowers to preserve the economic value of units and should not be considered as means to evergreen the advances.

Floating Provisions

VI.34 Floating provisions made by the banks could not be reversed by credit to the profit and loss account but could only be utilised for making specific provisions under extraordinary circumstances with the prior approval of the Reserve Bank. Until such utilisation, these provisions could be netted off from gross NPAs to arrive at net NPAs, or alternatively, they could be treated as part of the Tier II capital within the overall ceiling of 1.25 per cent of total risk weighted assets. The former option was, however, removed with effect from April 1, 2009. Further, it was decided to allow banks to utilise, at their discretion, the floating provisions held for ‘advances’ portfolio, to the extent of meeting such interest/charges waived under the Agricultural Debt Waiver and Debt Relief Scheme, 2008.

Unsecured Loans

VI.35 In order to enhance transparency and ensure correct reflection of the unsecured advances in banks’ balance sheets, it was advised that for determining the amount of unsecured advances that could be presented in schedule 9 of the published balance sheet, the rights, licenses, authorisations charged to the banks as collateral in respect of projects (including infrastructure projects) financed by them, should not be reckoned as tangible security. Hence, such advances would be reckoned as unsecured.

Off-balance Sheet Exposures

VI.36 For the purpose of computing credit exposure and also for computing capital adequacy, banks were advised in August 2008 to compute their credit exposures/credit equivalent, arising on account of the interest rate and foreign exchange derivative transactions and gold, using the ‘current exposure method’. The credit exposures computed would attract provisioning requirement as applicable to the loan assets in the ‘standard’ category of the concerned counterparties. In October 2008, banks were advised that the overdue receivables representing positive MTM value of a derivative contract would be treated as NPAs, if these remained unpaid for 90 days or more, and all other funded facilities of the client would be treated as NPA following the principle of borrower-wise classification. The principle of borrower-wise asset classification would apply to all overdues arising from forward contracts, plain vanilla swaps and options and other complex derivatives with the exception of complex derivative contracts entered into during the period between April 2007 and June 2008.

Anti Money Laundering Measures

VI.37 The Prevention of Money Laundering (Amendment) Act, 2009 [PMLA] received the assent of the President on March 6, 2009. The amendment sought, inter alia, to include payment system operators and ‘authorised persons’ as defined in Foreign Exchange Management Act, 1999 within the prevention of money laundering framework. The reporting guidelines for banks were updated during the year by the Reserve Bank, the salient features of which include:

(i) All cash transactions, where forged or counterfeit Indian currency notes were used as genuine, should be reported by the Principal Officer to the Financial Intelligence Unit – India (FIU-IND) immediately in the prescribed format – counterfeit currency report (CCR).

(ii) The background including all documents/office records/memorandums pertaining to all complex, unusually large transactions and all unusual patterns of transactions, which had no apparent economic or visible lawful purpose should, as far as possible, be examined and the findings at the branch as well as the Principal Officer level should be properly recorded. These records should be preserved for ten years as required under the PMLA, 2002.

(iii) It is likely that in some cases transactions are abandoned/aborted by customers on being asked to give some details or to provide documents. It was clarified that banks should report all such attempted transactions in suspicious transactions reports (STRs), even if not completed by customers, irrespective of the amount of the transaction.

(iv) While making STRs, banks should be guided by the definition of ‘suspicious transaction’ as contained in rule 2(g) of rules notified under PMLA, 2002. STRs should be made if there was reasonable ground to believe that the transaction involved proceeds of crime, irrespective of the amount of the transaction and/or the threshold limit envisaged for predicate offences in part B of schedule of PMLA, 2002.

(v) In the context of creating KYC/anti-money laundering awareness among the staff and for generating alerts for suspicious transactions, banks were advised to consider the indicative list of suspicious activities contained in the IBA’s Guidance Note for Banks, 2005.

Customer Service

VI.38 During the year, many important initiatives were taken for improving customer service in banks. In order to make available all current instructions on the subject at one place, several important instructions relating to customer service were compiled in the form of a Master Circular, which was issued on November 3, 2008.

VI.39 Based on the experience gained in running the Banking Ombudsman Scheme, 2006, a revision to the Scheme was effected in February 2009. The salient features of the amendments include widening of the scope of the Scheme to consider deficiencies arising out of internet banking services, enabling customers to lodge complaints against banks for their non-adherence to the provisions of the Fair Practices Code for Lenders or the Code of Bank’s Commitment to Customers and non-observance of the Reserve Bank’s guidelines on engagement of recovery agents. The Reserve Bank also asked all banks to place a copy of the Banking Ombudsman Scheme, 2006, on their websites, for wider dissemination.

VI.40 Banks were reported to be levying high service charges for collection of outstation cheques and for use of certain electronic remittance/transfer of funds services. To reduce the complaints in this regard, instructions were issued in October 2008 for uniform service charges for electronic payment products and also charges for collection of outstation cheques.

VI.41 The Committee on Customer Services (Chairman: Shri H. Prabhakar Rao) submitted its report in April 2008 and covered matters relating to currency management, Government business, inclusive of payment of pension and taxes and foreign exchange services (Box VI.4).

VI.42 Banks were advised in August 2008 to conduct an annual review of accounts in which there were no operations for more than one year and procedures for tracing the customers, ascertaining the reasons for inactivity in the account and labelling the account as inoperative/dormant where there were no transactions for over a period of two years, and payment of interest on savings bank account were prescribed. Since one of the objectives of the segregation of the inoperative accounts was to reduce the risk of frauds, the transaction should be monitored by banks at a higher level both from the point of view of preventing fraud and making an STR.

VI.43 As display of customer-friendly information by banks in their branches is one of the modes of imparting financial education, commercial banks were advised to put the important aspects or mandatory instructions relating to ‘customer service information’, ‘interest rates’, ‘service charges’, ‘grievance redressal’ and ‘others’ on a comprehensive notice board and make the detailed information available in booklets/ brochures.

VI.44 During the year, instructions were issued to banks to ensure that their branches invariably accepted cash over the counter from all customers who desired to do so; to ensure that all information relating to charges/fees for processing were invariably disclosed in the loan application forms and to inform the ‘all-in-cost’ to the customers to enable them to compare the rates charged with other alternative sources of finance; to indicate the name of the nominee in the passbook/statement of account with the consent of the customer; and to provide ramps in ATMs /bank branches and also to make at least one-third of new ATMs installed as talking ATMs with Braille keypads.

VI.45 At present, interest on savings bank accounts is calculated on the minimum balances held in the accounts during the period from the tenth day to the last day of each calendar month. In view of the present satisfactory level of computerisation and extensive networking in commercial banks, and in line with the announcement in the Annual Policy Statement for 2009-10, it is proposed that the payment of interest on savings bank accounts by SCBs would be on a daily product basis with effect from April 1, 2010.

Box VI.4
Committee on Customer Services

The Reserve Bank had set up the Committee on Customer Services (Chairman: Shri H. Prabhakar Rao) to look into customer services provided by the Reserve Bank directly or through banks/institutions with a view to maximising general public satisfaction. The major recommendations made by the Committee include:

Payment of Government Pension through Public Sector Banks:

• Branch manager should interact with a cross-section of pensioners serviced at the branch on a quarterly basis.

• Banks should follow-up actively and ensure that, wherever possible, pensioners who had retired earlier convert their pension accounts to joint accounts. Nominations should invariably be taken.

• Banks should organise regular training sessions for bank personnel dealing with pension matters in consultation with the concerned Government Department.

• Banks should establish a Centralised Pension Payment Cell (CPPC) to take over back-office work relating to disbursement of Government pension.

Collection of Taxes by Agency Banks (Online Tax Accounting System - OLTAS):

• All banks were advised to ensure that all concerned staff were appropriately trained to the requirements of the OLTAS and were also sensitised to the needs of the individual assessees.

• All bank branches authorised to accept payment of income tax should clearly and prominently display the fact by way of a notice/board.

• Banks were advised to put up notices in their branches asking assessees to quote correct PAN number, assessment year and other details in the challan. Further, an easy to read/comprehend list of “Do’s and Don’ts” is required to be put up as a notice for the guidance of customers.

• Banks should strictly follow the process of verification of the PAN number of existing assessees to eliminate any incorrect entry by the assessees.

• Banks should provide blank printed challans for the convenience of the assessees who could not obtain pre-verified, pre-printed challans over the internet.

• Tax collecting bank branches should invariably give paper token in acknowledgement of the receipt of the cheque.

• All banks should set up e-payment facilities in a time-bound manner.

Issue and Operations of ‘Savings Bonds’:

• Instructions were issued to banks to ensure that every branch conducting Government business of volume above a specified amount (say Rs.25 lakh) was covered by concurrent audit. The scope of the concurrent audit should be prescribed to include various aspects of servicing of savings bonds with specific reference to the customer service related aspects.

• Each bank was asked to automate the processing related to the servicing of savings bonds to ensure the timely servicing of the bonds.

• Banks were advised to actively make efforts to obtain the bank accounts details of the investors in order to migrate to electronic servicing of interest and maturity proceeds of the savings bonds through the electronic clearing service and the national electronic funds transfer.

• Banks were advised to obtain the opinion and views of the investors on the quality of the services rendered by the authorised agencies by means of a survey or questionnaires.

Additionally, the Reserve Bank took the following initiatives:

• Frequently Asked Questions (FAQs) relating to pension disbursement by the public sector banks under the Central Government pension schemes were hosted on the Reserve Bank’s website in June 2008.

• A checklist relating to pension payments/Government business for use of internal inspection of bank branches was forwarded to banks advising them to issue instructions to their internal auditors/inspectors to bestow due attention to adherence to the items of work listed therein and comment on the quality of customer service in their report.

• Efforts were made to extend the electronic payment network to more locations in the country so that every investor could opt for receiving interest and repayment proceeds of Saving Bonds directly into his/her account.

VI.46 Detailed instructions were issued to banks in July 2008 on their credit card operations covering aspects such as issue of unsolicited cards, insurance cover to credit card holders, safeguards against misuse of lost/stolen cards, educating customers on the implications of paying only the ‘minimum amount due’ on credit cards, excessive interest/other charges, escalation of unresolved complaints, reporting to Credit Information Bureau of India Ltd./CICs, registration of telemarketers, wrongful billing and redressal of grievances.

VI.47 With a view to enhancing awareness about the Codes evolved by the Banking Codes and Standards Board of India, the BCSBI launched a quarterly newsletter titled “Customer Matters”, which was distributed to each branch of each member bank. The BCSBI invited suggestions from members of the public, Banking Ombudsmen, various bodies representing interests of banks' customers, and has now completed the process of review of the Code of Bank’s Commitment to Customers, in collaboration with the IBA. Public grievance is an effective tool through which the BCSBI carries out its ongoing monitoring of banks’ compliance with the Code provisions. The BCSBI, by design and mandate, is not a redressal agency to arbitrate on a dispute between an individual and his/her bank but grievances ventilated by individuals sometimes throw up issues on systemic deficiencies. They enable the BCSBI to monitor Code compliances at system or bank-specific level.

Supervisory Initiatives

VI.48 An Internal Working Group constituted to lay down the road map for adoption of a suitable framework for cross-border supervision and supervisory co-operation with overseas regulators submitted its Report in January 2009. The recommendations of the Group are being examined for initiating further action. An Inter-departmental Group is also examining additional areas/issues which need to be brought under the supervisory focus, including modalities for on-site supervision of overseas branches and subsidiaries of Indian banks. The Group is expected to submit its Report shortly. Keeping in view the systemic importance of financial conglomerates (FCs), efforts are being initiated to strengthen the FC monitoring system further by introducing certain prudential measures such as group-wide capital adequacy requirements, safe conduct of Intra-Group Transactions and Exposures (ITEs) and management of risk concentrations, governance systems in FCs including ‘fit and proper’ principles and risk management systems, supervisory co-operation and information-sharing amongst the sectoral regulators.

VI.49 Banks were advised to be extremely cautious while continuing relationships with respondent banks located in countries with poor KYC standards and countries identified as ‘uncooperative’ in the fight against money laundering and terrorist financing. The anti-money laundering (AML)/combating financing of terrorism (CFT) guidelines issued by the Reserve Bank are in consonance with the Financial Action Task Force (FATF) recommendations. Increased disclosure requirements have been emphasised on the part of tax payers and financial institutions for transactions involving uncooperative jurisdictions. The Reserve Bank would continue to incorporate the latest international best practices in its regulations.

Off-Site Returns

VI.50 Off-site supervision, introduced in 1995, has steadily become an integral component of the Reserve Bank’s financial stability architecture, providing early warning on weaknesses at the bank level as well as the system level. In order to maintain its effectiveness, changes have been continually incorporated into the off-site surveillance system in alignment with the evolving international practices as also the country-specific needs.

VI.51 As part of the policy decision to receive all regulatory returns through a secured online returns filing system (ORFS), the existing periodic prudential off-site returns submitted by banks are being migrated to the ORFS in a phased manner. After migrating the fortnightly return on liquidity (statement of structural liquidity) from February 2008, four more returns, viz., report on sensitivity to interest rate - both rupee and foreign exchange, report on maturity and position and report on subsidiaries/joint ventures/associates, were successfully migrated to ORFS from January 2009. A new return on capital adequacy as per Basel II was developed using extensible Business Reporting Language (XBRL) and integrated with the existing ORFS. The benefits of ORFS include ease of compilation, speedy submission, monitoring of receipts, scope for incorporating changes in the returns and maintenance of the system.

Monitoring of Frauds

VI.52 The fraud monitoring function of the Reserve Bank has assumed greater significance in recent years as there has been an increase in the number of frauds involving larger amounts. Frauds have been noticed in traditional as also new areas, such as housing loans, credit cards, internet banking and outsourcing business (Table 6.6).

VI.53 The complexity of cases is increasingly exposing banks to greater operational risk. The Reserve Bank, as part of its supervisory process, has been sensitising banks from time to time about common fraud-prone areas, modus operandi of frauds and the measures to be taken to prevent/ reduce the incidence of frauds.

VI.54 During the year 2008-09, 102 caution advices were issued to banks by the Reserve Bank (through secured e-mail) in respect of unscrupulous borrowers who perpetrated frauds of amounts exceeding Rs.25 lakh, so that banks could exercise due care while considering sanction of credit facilities to them. With a view to putting in place some deterrent action against entities such as builders, warehouse owners, chartered accountants, lawyers and valuers of properties, who do not have any contractual relationship with banks, it was decided that banks could inform the IBA about the names of such entities so that the IBA could prepare a caution list for circulation amongst banks. A circular was issued to banks in March 2009 in this regard.

VI.55 During the economic slowdown in 2008-09, the need for proactive credit expansion for stimulating the economy, especially in certain specified segments such as housing and infrastructure was recognised. There is, however, a potential scope for internal controls getting relaxed due to the exigency of credit expansion. Weaker standards of control and risk management tend to facilitate frauds, especially when rapid credit expansion has to be achieved in a slowing economy. Therefore, appropriate precaution needs to be integrated into the bank oversight structure. In this context, the Reserve Bank proposes to evolve a prudential approach to fraud oversight as against the existing legal approach. The approach would seek to align the supervisory oversight on frauds with the Supervisory Review and Evaluation Process (SREP) under Pillar 2 of Basel II by factoring in the sharp rise in frauds, while profiling the operational risks facing the banks.

URBAN CO-OPERATIVE BANKS

VI.56 The Primary (Urban) Co-operative Banks (UCBs) play an important role as financial intermediaries in urban and semi-urban areas catering to the needs of the non-agricultural sector, particularly small borrowers. In the context of their role in the national economy, several initiatives are being taken by the Reserve Bank to help the sector to grow on sound lines. The Reserve Bank has entered into MoUs with 26 State Governments and with the Central Government (for multi-State UCBs) and Task Forces on Urban Co-operative Banks (TAFCUBs) were constituted in these States and at the Centre for identification of non-viable UCBs and deciding their future set up. The MoU arrangement now covers over 99 per cent of the banks that account for over 99 per cent of deposits in the sector.

VI.57 With a view to providing an additional avenue for non-disruptive exit of weak/unviable entities in the co-operative banking sector, the Reserve Bank issued guidelines on merger/ amalgamation of UCBs with Deposit Insurance and Credit Guarantee Corporation (DICGC) support in January 2009. UCBs with negative net worth were permitted to restructure their liabilities and convert a part of deposits of the large depositors having deposits of Rs.1 lakh and above and those of co-operative institutions into equity capital and Innovative Perpetual Debt Instruments (IPDIs) so as to restore viability to the restructured banks. In order to protect the interests of the depositors, the Reserve Bank also permitted transfer of assets and liabilities of a mid-sized UCB to a public sector commercial bank. To overcome the difficulties in raising of capital funds and achieving the prescribed CRAR of 9 per cent, the Reserve Bank issued guidelines for raising of capital by way of preference shares and long-term deposits. With the comfort of coordinated supervision, UCBs in States which had signed the MoUs, were permitted to open currency chests, sell units of mutual funds and insurance products, provide foreign exchange services, open new ATMs and convert extension counters into branches. Further, banks were granted authorisation to open new branches.

VI.58 There has been a change in the profile of the sector due to measures taken in recent times. The number of banks in Grade I or II have increased significantly from 1,147 (61 per cent of the total of 1,872 banks) as on March 31, 2005 to 1,326 (77 per cent of total of 1,721 banks) as on March 31, 2009. The number of Grade III and Grade IV UCBs taken together, (implying weakness/sickness in UCBs) have similarly declined from 725 (39 per cent of the total) as on March 31, 2005 to 395 banks (23 per cent of total) as on March 31, 2009.

Branch Expansion

VI.59 Sound and well-functioning Tier II UCBs in States that had signed MoUs were provided avenues for organic growth as they could submit applications to the Reserve Bank for extension of their areas of operation to the entire State. The branch licensing norms for such Tier I and Tier II UCBs were further liberalised in 2008-09 and it was decided that approvals for branch expansion, including off-site ATMs would be considered subject to satisfaction of certain criteria. The eligibility norms for opening up of on-site ATMs were liberalised following the announcement to the effect in the Annual Policy Statement for 2008-09.

Financial Restructuring

VI.60 UCBs were advised that, subject to certain conditions, their proposals for financial restructuring would be considered as an additional option for resolution of problem banks.

Prudential Guidelines

VI.61 The proportion of SLR holdings in the form of Government and other approved securities as percentage of NDTL was revised and non-scheduled UCBs were asked to maintain SLR of 7.5 per cent by September 30, 2009, 15 per cent by March 31, 2010 and 25 per cent by March 31, 2011. Non-SLR investments of UCBs continue to be limited to 10 per cent of a bank’s total deposits as on March 31 of the previous year.

VI.62 In view of the economic downturn in 2008-09, which created stress on liquidity and repayment capability of the otherwise viable units, revised guidelines were issued to UCBs on restructuring of advances, applicable to all accounts restructured after March 6, 2009 (i.e., the date of issue of the circular). Under the revised guidelines, special regulatory treatment is available to the borrowers engaged in important business activities, subject to compliance with certain conditions. The special regulatory treatment has two components – incentive for quick implementation of the restructuring package and asset classification benefits.

VI.63 In respect of legacy cases pertaining to UCBs having negative net worth as on March 31, 2007, it was decided that Reserve Bank would consider a scheme of amalgamation that provides for payment to depositors, financial contribution by the transferee bank and sacrifice by large depositors. The detailed guidelines for merger of UCBs in such legacy cases were laid down together with guidelines for valuation of assets and liabilities of the transferor bank and the additional incentives that could be provided to the transferee bank.

Regulatory Initiatives

VI.64 More granular asset-liability management guidelines (splitting the first time bucket in the statement of structural liquidity into three buckets) became effective for scheduled UCBs from January 1, 2009. Consequent to the announcement in the Annual Policy Statement for 2008-09, Tier II UCBs were permitted to extend individual housing loans up to a maximum of Rs.50 lakh (Rs.25 lakh earlier) per beneficiary of a dwelling unit subject to extant prudential exposure limits.

Customer Service

VI.65 All UCBs were advised to conform to the time frame prescribed by the National Consumer Dispute Redressal Commission in the matter of clearance of cheques. For delays beyond the stipulated period, banks should pay interest at the fixed deposit rate or at the specified rate as per the respective bank’s policy, to the payee of the cheques.

VI.66 Notifications oriented towards customer service issued to UCBs by the Reserve Bank during 2008-09 include instructions regarding display of information by banks on comprehensive notice boards, display of information relating to interest rates and service charges and need to make bank branches and ATMs accessible to persons with disabilities. Since visually challenged persons were legally competent to enter into business contracts, UCBs were advised to ensure that all banking facilities such as cheque book facility (including third-party cheques), ATM facility, net banking facility, locker facility, retail loans, and credit cards were invariably offered to the visually challenged without any discrimination. UCBs were advised to ensure that a suitable mechanism existed for receiving and addressing complaints from their customers with specific emphasis on resolving such complaints fairly and expeditiously regardless of the source of the complaints.

Business Facilitation

VI.67 UCBs, which are recognised as authorised dealer category I and II, could participate in designated currency futures exchanges recognised by the SEBI as clients, only for the purpose of hedging their underlying foreign exchange exposures.

Mergers and Amalgamations

VI.68 The process of consolidation of the sector through the merger of weak entities with stronger ones has been set in motion by providing transparent and objective guidelines for granting no-objection to merger proposals (Box VI.5). The Reserve Bank, while considering proposals for merger/amalgamation, confines its approval to the financial aspects of the merger, taking into consideration the interests of the depositors and financial stability. Invariably, it is a voluntary decision of the banks that approach the Reserve Bank for obtaining no objection for their merger proposal. As of end-June 2009, 71 UCBs had been merged, with 50 being Grade IV banks of which 44 had negative net worth.

RURAL CO-OPERATIVES

VI.69 The Government of India had constituted a Task Force on Revival of Short-Term Rural Co-operative Credit Institutions to propose an action plan for reviving the rural co-operative banking institutions and suggest an appropriate regulatory framework for these institutions. In order to give a further fillip to the co-operative banking sector, the Task Force also undertook a study on revival of long-term co-operative credit structure in the country (Box VI.6).

Box VI.5
Merger and Amalgamation of UCBs

With a view to facilitating consolidation and emergence of strong entities as well as for providing an avenue for non-disruptive exit of weak/unviable entities in the co-operative banking sector, the Reserve Bank issued guidelines on merger/amalgamation of UCBs in February 2005.

An elaborate process is followed for merger and amalgamation. The merger proposal has to be submitted by the acquirer bank to the Registrar of Co-operative Societies (RCS)/Central Registrar of Co-operative Societies (CRCS) and a copy of the proposal is also simultaneously forwarded to the Reserve Bank along with certain specified information. The Reserve Bank examines the proposals and places the same before an Expert Group for screening of applications of merger and amalgamation. On evaluation, if the proposal is found to be suitable, the Reserve Bank issues no objection certificate (NOC) to the RCS/CRCS and the banks concerned. The RCS/CRCS then issue the order of amalgamation of the target UCB in compliance with the provisions of the Co-operative Societies Act under which the bank is registered.

In legacy cases pertaining to UCBs having negative net worth as on March 31, 2007, it has been decided that the Bank may also consider scheme of merger that provides payment to depositors under Section 16 (2) of the DICGC Act, 1961, financial contribution by the transferee bank and sacrifice by large depositors. Additional incentives were provided to the transferor bank on merger. The additional incentives include permission for closure of loss making branches of the transferor bank, shifting/relocation of branches of the transferor bank within the area of operations, retention of facilities such as Authorised Dealer licence where higher level of CRAR at 12 per cent was prescribed on an ongoing basis provided the bank maintained the benchmark CRAR of 9 per cent, minimum entry point norm of Rs.50 crore not being insisted for a bank to become multi-State on account of taking over another UCB registered outside the State.

Pursuant to the issue of the guidelines, the Reserve Bank received 119 proposals for merger in respect of 104 banks. The Reserve Bank has issued NOCs in 82 cases. Of these, 71 mergers became effective upon the issue of statutory orders by the concerned RCS/CRCS. 21 proposals for merger were rejected by the Reserve Bank, three proposals were withdrawn by the banks and the remaining 13 are under consideration. Out of the 71 banks for which orders of merger were received from the RCS/CRCS, 44 had negative net worth. The profit making banks were also permitted to merge with the aim of strengthening the sector and in some cases, because they were not considered to be viable on a stand-alone basis in the long run.

VI.70 The Reserve Bank regulates state co­operative banks (St.CBs) and district central co­operative banks (DCCBs) under the Banking Regulation Act, 1949, (AACS) while NABARD supervises them. Only 14 out of the 31 St.CBs and 75 out of the 371 DCCBs have been granted licences by the Reserve Bank so far. 16 St.CBs have also been granted scheduled status under Section 42 of the Reserve Bank of India Act, 1934.

VI.71 The CFSA had observed that there was a need to draw up a roadmap for ensuring that only licensed banks operated in the co-operative space by the year 2012. This would expedite the process of consolidation and weeding out of non-viable entities from the co-operative space. Accordingly, it was announced in the Annual Policy Statement for 2009-10 that a roadmap would be worked out for achieving this objective in a non-disruptive manner in consultation with NABARD. The discussions with NABARD have been initiated in the matter.

REGIONAL RURAL BANKS

VI.72 The process of consolidation through amalgamation of RRBs is now almost complete, resulting in a decline in the total number of RRBs to 86 as on March 2009 (which includes a new RRB set up in the Union Territory of Puducherry) and further to 84 as on July 31, 2009. The process of recapitalisation of RRBs with negative net worth is complete, with 27 RRBs fully recapitalised with an amount of Rs.1,796 crore at end-July 2009.

Box VI.6
Revival of Co-operative Credit Structure

Recognising the continued significance of the co­operative credit structure in the economy, despite the significant spread of banks and non-banks to all regions of the country and taking into account the deep-rooted integration of the co-operative structure in the Indian socio-economic systems, the Government of India had constituted a Task Force on Revival of Short-Term Rural Co-operative Credit Institutions (Chairman: Prof. A. Vaidyanathan). The Task Force submitted its report to the Central Government in February 2005. Based on the recommendations of the Task Force and in consultation with the State Governments, the Government of India had approved a package for revival of the Short Term Rural Co-operative Credit Structure, which consists of Primary Agricultural Credit Societies (PACS) at the village/base level, Central Co-operative Banks (CCBs) at the intermediate level and the State Co-operative Banks (StCBs) at the apex level. The revival package aims at reviving the short-term rural co-operative credit structure to make it a well-managed and vibrant medium to serve the credit needs of rural India, especially the small and marginal farmers. The package seeks to: (i) provide financial assistance to bring the system to an acceptable level of health; (ii) introduce legal and institutional reforms necessary for its democratic, self- reliant and efficient functioning; and (iii) take measures to improve the quality of management.

The total financial assistance under the revival package is estimated at Rs.13,596 crore. The liability for funding the financial package would be shared by the Central Government, the State Government and the co-operative credit structure based on the origin of losses and existing commitments. The financial assistance would be released only on the implementation of the recommendation for legal and institutional reforms. The States willing to participate were required to enter into a MoU with the Central Government and NABARD. So far, twenty-five States have executed MoUs with the Government of India and the NABARD, as envisaged under the package. This covers more than 96 per cent of the short-term co-operative credit structure units in the country.

Ten States, namely, Andhra Pradesh, Bihar, Gujarat, Haryana, Madhya Pradesh, Maharashtra, Meghalaya, Orissa, Tamil Nadu and Uttar Pradesh had made necessary amendments in their Cooperative Societies Acts as at end-June 2009. The State Governments of Chhattisgarh and West Bengal have taken a Cabinet decision approving the amendments in respect of the reform measures as they have submitted their new State Cooperative Societies Acts to Hon’ble President for assent. Draft amendments to Co-operative Societies Acts of Arunachal Pradesh, Assam, Karnataka, Punjab, Rajasthan, Tripura, Uttarakhand, Sikkim, Jharkhand, Jammu and Kashmir, Mizoram, Manipur and Meghalaya are under consideration.

As required in the revival package, the Reserve Bank has prescribed ‘fit and proper’ criteria for the Directors and CEOs of the StCBs and CCBs for circulation amongst the concerned banks through NABARD. An aggregate amount of Rs.6,170.3 crore had been released by NABARD as the Government of India’s share for recapitalisation of PACS in ten States namely, Andhra Pradesh, Chhattisgarh, Gujarat, Haryana, Madhya Pradesh, Maharashtra, Orissa, Tamil Nadu, Uttar Pradesh and West Bengal, as on June 30, 2009, while the State Governments had released their share of Rs.614.8 crore. The National Implementing and Monitoring Committee, set up by the Government of India, is guiding and monitoring the implementation of the revival package on an all-India basis.

Furthermore, the study of the long-term cooperative credit structure was entrusted by the Government to the same Task Force. The Report was submitted in August 2006. It was announced in the Union Budget for 2008-09 that the Central Government and the State Governments had reached an agreement on the content of the package for revival of the long-term cooperative credit structure. The cost of the package was estimated at Rs.3,074 crore, of which the Central Government’s share would be Rs.2,642 crore.

VI.73 With effect from the fortnight beginning February 28, 2009, penalty is imposed on those RRBs which default in maintenance of SLR. The exemption granted to RRBs from the purview of Section 31 of the Banking Regulation Act, 1949 in regard to publishing their balance sheet was also withdrawn, effective from the financial year ending March 31, 2009.

VI.74 Measures taken to further liberalise the branch licensing policy for RRBs during 2008-09 include relaxation of conditions for opening branches in hitherto uncovered districts and opening of service branches/central processing centres/back offices. During 2008-09, the Reserve Bank granted 780 licences to RRBs for opening branches, of which 690 were opened.

VI.75 The CFSA had suggested a phased introduction of CRAR in RRBs, along with the recapitalisation, after consolidation of these entities. It was, therefore, announced in the Annual Policy Statement for 2009-10 to introduce CRAR for RRBs in a phased manner, taking into account the status of recapitalisation and amalgamation. A time-table for this purpose would be announced in consultation with NABARD. Accordingly, NABARD has been advised to constitute a Working Group to suggest bank-wise actionable measures for RRBs which had CRAR less than 1 per cent as on March 31, 2008 so that they could achieve the target of 7 per cent by March 2010.

VI.76 In order to prepare the RRBs to adopt appropriate technology and migrate to core banking solutions (CBS) for better customer services, a Working Group (Chairman: Shri G. Srinivasan) was constituted to prepare a roadmap for migration to CBS by the RRBs. The Working Group reviewed the present status of computerisation in RRBs and viewed that RRBs could not remain isolated from the technological developments sweeping the banking sector and that the “one strategy fits all” approach was not workable. The Group also examined the use of solar power as an alternative source of energy for powering branches located in remote places and suggested that although heavy initial cost was involved in installation of solar power units, the long-term benefits would justify powering branches through solar power. The Report, among other things, set September 2011 as the target for all RRBs to move towards CBS, with all branches of RRBs opened after September 2009 to be CBS compliant from day one. The Report was forwarded to all sponsor banks to take necessary action.

VI.77 A Working Group (Chairman: Shri G. Padmanadbhan) was constituted to explore various affordable ICT-based solutions suitable for RRBs and to identify the cost elements and recommend the manner and criteria for funding such ICT solutions. The Group examined the existing constraints, both financial and infrastructural, in adoption of financial inclusion initiatives by the RRBs. It also explored the various available technology options and suggested modalities for the Reserve Bank’s support to finance ICT solutions for the RRBs. It was announced in the Annual Policy Statement for 2009-10 that a scheme would be worked out, in consultation with NABARD, to decide the manner of providing assistance to RRBs adopting ICT solutions for financial inclusion in districts identified as having high level of exclusion.

ALL INDIA FINANCIAL INSTITUTIONS (AIFIs)

VI.78 As at end-March 2009, there were four institutions, viz., EXIM Bank, NABARD, NHB and SIDBI, regulated by the Reserve Bank as all-India Financial Institutions (AIFIs). In the wake of the emerging global developments and their impact on financial institutions, the Reserve Bank received requests from select AIFIs for liquidity support for on-lending to HFCs/NBFCs/MFIs and exporters, and accordingly, took a number of measures.

VI.79 In December 2008, the Reserve Bank sanctioned refinance facilities of Rs.7,000 crore, Rs.5,000 crore and Rs.4,000 crore for SIDBI, EXIM Bank and NHB, respectively, under the relevant provisions of the Reserve Bank of India Act, 1934. The availment of refinance by the above AIFIs under this facility is restricted to a period of 90 days and the amount could be flexibly drawn and repaid during the period. The facility could be rolled over and would be available up to March 31, 2010. Advances under this facility are charged at the repo rate under the LAF of the Reserve Bank. The funds provided under the refinance facility should be utilised as per the policy approved by the Board of the respective financial institution, and in adherence with the extant exposure norms for these entities. To facilitate monitoring, the financial institutions are required to submit a weekly report on the utilisation of the refinance facility. The amount outstanding under the special refinance facility remained small up to February 2009 for each institution but picked up subsequently (Table 6.7).

VI.80 The ceiling on aggregate resources mobilised by SIDBI, NHB and EXIM Bank was raised subject to conditions, with effect from December 8, 2008, for a period of one year. The guidelines regarding restructuring of advances issued to banks have been mutatis mutandis applied to the select AIFIs. Provisions relating to certain activities generally not undertaken by FIs, such as extending working capital, overdrafts and personal loans would, however, not be applicable to them.

NON-BANKING FINANCIAL COMPANIES

VI.81 Traditionally, deposit taking NBFCs (NBFCs-D) were subjected to prudential regulation on various aspects of their functioning while the non-deposit taking NBFCs (NBFCs-ND) were subject to minimal regulation. In the light of the growing integration of the financial sector, it was felt that all systemically relevant entities offering financial services ought to be brought under a suitable regulatory framework to contain systemic risk. Therefore, as a first step, in December 2006 all NBFCs-ND with an asset size of Rs.100 crore and above as per the last audited balance sheet were designated as systemically important NBFCs-ND (NBFCs-ND-SI) and a specific regulatory framework was put in place from April 1, 2007 for such entities.

VI.82 On a review of the experience with the regulatory framework, it was felt desirable to enhance the capital adequacy requirement and put in place guidelines for liquidity management and reporting, as also norms for disclosures. Thus, NBFCs-ND-SI were advised to attain minimum CRAR of 12 per cent by March 31, 2010 and 15 per cent by March 31, 2011.

VI.83 In April 2008, existing instructions on KYC norms and AML/CFT standards were reviewed with regard to identification of customers to ensure that NBFCs kept in mind the spirit of instructions issued by the Reserve Bank and avoided undue hardshipsto individuals who were otherwise classified as low risk customers. It was advised that NBFCs should update the consolidated list of high risk individuals and entities as circulated by the Reserve Bank. Further, the updated list of such individuals/entities could be accessed from the United Nations’ website. While the names of their new customers should not appear in the list, NBFCs should also put in place an adequate screening mechanism as an integral part of their recruitment/hiring process. Obligations of NBFCs in terms of rules notified under PMLA 2002 and certain clarifications regarding CTRs and STRs were revised in August 2008. These were in line with the instructions issued to commercial banks.

VI.84 To ensure a measured movement towards strengthening the financials of all deposit taking NBFCs, in June 2008, NBFCs-D with a minimum net owned fund (NOF) of less than Rs.200 lakh were asked to freeze their deposits, and bring it down to the revised ceiling of deposits, which in turn was dependent on the extent by which their NOF was less than the prescribed minimum of Rs.200 lakh.

VI.85 Statutory auditors play an important role in assisting the Reserve Bank in supervision of the NBFCs which are large in number. Earlier directions to statutory auditors were issued way back in 1998. Given the changed operating environment since then, updated and consolidated instructions encompassing supervision of both NBFCs-D as well as NBFCs-ND were issued to the auditors of NBFCs in September 2008.

VI.86 To enhance the focus on the NBFCs-ND with asset size of Rs.50 crore and above but less than Rs.100 crore (which were earlier not supervised), it was decided to call for basic information from non-deposit taking NBFCs with asset size between Rs.50 crore and Rs.100 crore at quarterly intervals. To ensure better supervision, all NBFCs (both deposit taking and non-deposit taking) with asset size of Rs.100 crore and above were asked to furnish the information about downgrading/upgrading of the assigned rating of any financial product issued by them, within fifteen days of such a change in the rating.

VI.87 On account of intensification of the global financial crisis in September 2008, some immediate impact was felt in the domestic capital markets, resulting in redemption pressure on mutual funds, which created liquidity constraints for NBFCs. In response, the Reserve Bank introduced special fixed rate Repo under LAF to banks exclusively for the purpose of meeting the funding requirements of mutual funds and NBFCs. The precautionary measures taken by the Reserve Bank since October 2008 to enhance the availability of liquidity to NBFCs are:

(i) Taking into consideration, the need for enhanced funds for increasing business and meeting regulatory requirements, it was decided that NBFCs-ND-SI could augment their capital funds by issue of Perpetual Debt Instruments (PDI) in accordance with the stipulated guidelines. Such PDI would be eligible for inclusion as Tier I capital to the extent of 15 per cent of total Tier I capital as on March 31 of the previous accounting year and the excess amount would qualify as Tier II capital within the eligible limits. The minimum investment in each such issue/tranche by a single investor would not be less than Rs.5 lakh. The amount of funds raised by NBFCs-ND-SI would not be treated as ‘public deposit’ within the meaning of Reserve Bank directives in this regard.

(ii) NBFCs-ND-SI which were facing problems of liquidity and ALM mismatch in the existent economic scenario were permitted, as a temporary measure, to raise short-term foreign currency borrowings under the approval route, subject to certain conditions.

(iii) To ease the flow of bank credit to the NBFCs, certain changes initiated were: (a) standard asset provisioning required to be made by banks on advances to NBFCs was reduced from 2.0 per cent to 0.4 per cent; (b) the risk weight on banks’ exposure to NBFCs-ND-SI reduced to 100 per cent from 125 per cent earlier, irrespective of credit rating while exposure to AFCs which attracted risk weight of 150 per cent was also reduced to 100 per cent; and (c) banks were permitted, on a temporary basis, to avail liquidity support under the LAF window through relaxation in the maintenance of SLR to the extent of up to 1.5 per cent of their NDTL, exclusively for meeting the funding requirements of NBFCs and mutual funds.

(iv) A scheme for providing liquidity support to eligible NBFCs-ND-SI through an SPV for meeting the temporary liquidity mismatches in their operations was introduced. IDBI Stressed Asset Stabilisation Fund (SASF) Trust was notified as the SPV for undertaking this operation. The SPV would purchase short-term papers from eligible NBFCs-ND-SI to meet the temporary liquidity mismatches. The instruments would be CPs and CDs, with a residual maturity of not more than three months and rated as investment grade. The facility would not be available for any paper issued after September 30, 2009 and the SPV would cease to make fresh purchases after December 31, 2009 and would recover all dues by March 31, 2010. The rate of interest charged by the IDBI SASF Trust would be 12.0 per cent.

VI.88 These steps indirectly also helped in dealing with the market pressure which had been building up on the liquid and fixed maturity plan portfolios of mutual funds. In this context, a review of the impact of these measures/relaxations on release of credit by banks to mutual funds/NBFCs was carried out in mid-November 2008. The review revealed that during the period from October 14 to November 20, 2008, many banks availed liquidity support under the 14-day special fixed rate repo of the Reserve Bank funding to mutual funds against the collateral of CDs. Some banks also availed liquidity support under 14-day special fixed rate repo of the Reserve Bank against their funding to NBFCs against the collateral of receivables of their regular NBFC clients. Overall, the policy announcement had a salutary effect on the mutual funds that faced liquidity problems (Box VI.7).

Box VI.7
Liquidity Crisis – Implications for NBFCs

In view of the funding inter-linkages between NBFCs, mutual funds and commercial banks, when the contagion from the global financial crisis created selling pressures in the stock markets in India, the liquidity needs of the system as a whole had to be addressed by the Reserve Bank. The ripple effect of the US and European markets led to heavy redemption pressure on mutual funds, starting in September 2008, as several investors, especially institutional investors, started redeeming their investments in liquid funds/money market funds. Mutual funds are major subscribers to CPs and debentures issued by the NBFCs, besides CDs issued by banks. With the mutual funds facing redemption pressures and difficulties in rolling over the maturing investments, one of the prime sources of funds available to NBFCs dried up and, hence, there was no market for rollover of maturing short-term instruments floated by NBFCs for having regular access to market funding. Apart from this, there were reports that the liquidity crunch also made banks reluctant to lend to NBFCs. This heightened the perception that NBFCs were facing severe liquidity constraints. To ascertain the ground reality, a study involving discussions with a large number of NBFCs-ND-SI was initiated.

The discussions centered on the immediate issue of liquidity constraints faced by the NBFCs and their experience with the measures taken by the Reserve Bank to ease the situation. The focus areas for discussions were: (i) the profile, composition and maturity pattern of assets and liabilities; (ii) liquidity issues/constraints faced by the companies; (iii) measures taken for mitigation of such constraints; (iv) feedback on the easing measures taken by the Reserve Bank; (v) business strategy/plans of the NBFCs in the immediate future, including substitution of short-term funds, possibility of downsizing the balance sheet and growth plans; and (vi) real estate/capital market exposures.

It emerged from the discussions that based on their liquidity sensitivity to the changing market conditions, NBFCs could be categorised into four groups. The first group of companies had financed assets with long-term liabilities and small amounts of CPs and had no asset-liability mismatches, as they mainly had short-term assets and also back-up lines of credit. They constituted the largest group and covered nearly three fourths of the total assets of companies under discussion. Another minority group had asset-liability mismatches but these companies had foreign parents from whom funds could be received. This group represented only 2.0 per cent of the total assets of the NBFCs. The third group of companies had financed assets with a mix of short-term CPs and bank funds and had a mismatch within tolerance limits. They had around 6.0 per cent of the total assets of the NBFCs. The last group of companies had long-term assets and short-term liabilities and was facing liquidity problems. These companies accounted for 17.0 per cent of the total assets of the NBFCs.

There was a general view among the companies that funds had become costlier and that raising funds outside bank borrowings had become extremely difficult in view of the then market conditions. Further, banks were also reluctant to extend additional credit or increase credit to NBFCs. Some of the NBFCs had put on hold incremental disbursements as they were utilising inflows to repay their short-term obligations and uncertainty of funds flow did not encourage them to expand their balance sheets.

Loan companies were expecting a slight increase in delinquency rates, as they had ventured into riskier segments, viz., unsecured loans and retail finance. The investment companies anticipated difficulty in subscriptions to their CPs/ debentures for which mostly mutual funds and banks were their mainstay. A number of companies, particularly investment companies, that had significant exposure in the capital market also had not indicated any liquidity problems except in the first few weeks of October 2008 largely on account of the fact that the companies lent only up to 50.0 per cent of the market value and in some cases only up to 33.3 per cent, coupled with regular margin calls.

Thus, even though at some point it was widely perceived that the NBFCs were facing significant problems, in reality, only a small segment of the NBFCs had real liquidity constraints and the Reserve Bank’s timely and adequate liquidity interventions could address the problems over a short timeframe.

VI.89 In January 2009, the Boards of NBFCs were asked to adopt a well documented interest rate model taking into account the relevant factors to determine the interest rate to be charged on loans and advances. With reference to the queries raised regarding repossession of vehicles, the Reserve Bank clarified in April 2009 that NBFCs must have a built in re-possession clause in the contract/loan agreement with the borrower, which must be legally enforceable. In order to ensure transparency, the terms and conditions of the contract/loan agreement should also contain provisions regarding certain procedures and a copy of such terms and conditions must be made available to the borrowers.

Securitisation Companies/Reconstruction Companies

VI.90 The Reserve Bank revised the formats of quarterly   statements   to   be   submitted   by Securitisation Companies/ Reconstruction Companies (SCs/RCs) in September 2008. The revised statements would capture, inter alia, data on position of owned fund of the SCs/RCs (including FDI component); position of acquisition/realisation of financial assets from banks/FIs by the SCs/RCs in terms of the SARFAESI Act, 2002; and information as regards security receipts (SRs) issued, redeemed and outstanding at the end of particular quarter.

VI.91 It was clarified that a SC/RC was neither a ‘bank’ nor a ‘financial institution’ under the provisions of the SARFAESI Act. Therefore, the acquisition of financial assets by a SC/RC from another SC/RC would not be in conformity with the provisions of the said Act. There was, however, no bar on SCs/RCs deploying their funds for undertaking restructuring of acquired loan accounts with the sole purpose of realising their dues.

DEPOSIT INSURANCE AND CREDIT GUARANTEE CORPORATION OF INDIA

VI.92 The deposit insurance scheme at present covers commercial banks including local area banks and RRBs in all States and Union Territories. The number of registered insured banks as on March 31, 2009 stood at 2,307 comprising of 80 commercial banks, 86 RRBs, 4 local area banks and 2,137 co-operative banks. The extent of protection accorded to depositors in terms of percentage of the number of fully protected accounts to the total number of accounts and the amount of insured deposits to assessable deposits as on March 31, 2009 stood at 89.3 per cent and 56.2 per cent, respectively (Chart VI.1). The current level of insurance cover, at Rs.1 lakh, is 2.2 times per capita GDP as on March 31, 2009, as against the global average of around three times per capita GDP³ . During 2008-09, the Corporation settled aggregate claims worth Rs.228 crore in respect of one commercial bank and 75 co-operative banks.

Evolving Regulatory and Supervisory Regime in the Context of the Crisis

VI.93 The lessons from the financial crisis have provided the necessary motivation and rationale for revamping the financial stability architecture of countries, with a view to strengthening the systems and preventing systemic crisis. Policy makers all over the globe have been assessing whether – and to what extent – certain features of the financial system encouraged market excesses and the build­up of large financial imbalances. They have also been considering what changes need be made to the financial system and to the regulatory and supervisory frameworks so as to prevent similar financial crises in future (Box VI.8). Internationally, many countries are contemplating significant changes to the existing regulatory regimes, in terms of jurisdiction powers, operational systems and procedures. The financial regulation review in June 2009 by the US introduces a ‘systemic-risk regulation’ which includes a “Financial Services Oversight Council”, which would coordinate policy and identify emerging risks, among other roles. A new Banking Act has been introduced in the UK, which assigns the Bank of England a statutory role relating to the financial stability objective and also introduces a new special resolution regime for dealing with failing banks. A new Systemic Risk Board in the EU identifies EU-wide systemic risk and makes appropriate policy recommendations to mitigate the same. A new central bank law in Malaysia seeks to provide clarity on the role of the central bank in ensuring financial stability. The Financial Stability Board has been set up at the Bank for International Settlements and significant new initiatives have also been taken by the G-20, the overall focus of these international responses is to prevent another systemic crisis.

Box VI.8:
Evolving Regulatory Changes in Response to the Crisis: The Indian Position

Several regulatory and supervisory issues have surfaced from the financial crisis in the advanced countries. Following intense deliberations on these issues, national regulators are broadly highlighting the following for reforming their financial stability architecture:

i. Strengthening the minimum capital adequacy requirements, with a focus on both the quality and quantity of the capital, supplemented with an overall leverage ratio.

ii. Reducing the pro-cyclicality attached to the regulatory framework (Basel II) through introduction of dynamic provisioning or counter - cyclical capital requirements.

iii. Macro-prudential analysis to study the interactions between the economy and the financial system and to provide early warning signals about the risks to the financial system and to the economy.

iv. Monitoring and supervision of large and complex banks, especially those which have cross-border presence and institution of ‘college of supervisors’ for effective cross-border supervision and supervisory co-operation.

v. Strengthening the individual bank’s risk management framework, especially for off-balance sheet items and need for stress testing, regulation and supervision of liquidity at micro (individual banks) and macro (systemic) level.

vi. Strengthening the corporate governance, including adoption of ‘fit and proper’ norms by the Board and the senior management of a bank.

vii. Extending regulation and supervision to all markets and institutions which are systemically important, even if they are non-deposit taking institutions/not directly dealing with the public.

viii. Creation of central counterparties in OTC derivatives trading.

ix. Considering alternative approaches for recognising and measuring loan losses that incorporate a broader range of available credit information; examining changes to relevant standards to dampen adverse dynamics associated with fair value accounting, including improvements to valuations when data or modeling may be weak.

x. Reducing the complexity of accounting standards for financial instruments and improving presentation standards to allow the users of financial statements to better assess the uncertainty surrounding the valuation of financial instruments.

The Indian regulatory structure for the entire financial system would respond appropriately to the emerging international initiatives, modulating the changes to country-specific needs. The well thought out and calibrated approach adopted by India while globalising the financial system in a phased manner commensurate with the system’s preparedness in terms of risk management and technology was instrumental in avoiding the direct harmful effects of the contagion on the domestic financial system weathering the crisis to a large extent. Several measures have been initiated in recent years, as detailed earlier in the Chapter, for strengthening the regulatory and supervisory functions of the Reserve Bank. Management of private pools of capital is not a major concern in India as venture capital funds and mutual funds are registered and regulated by the SEBI, while hedge funds do not operate in India at present. The High Level Co-ordination Committee on Financial Markets (HLCCFM) provides a coordination mechanism among financial sector regulators, viz., Reserve Bank, SEBI, IRDA and PFRDA. It is supported by other technical committees/sub-committees, which examine issues relating to entities under various regulators that have cross-sector implications.

Since end-March 2009, all the SCBs in India have migrated to the Basel II framework and would be subjected to the supervisory review and evaluation process (SREP) under Pillar 2 of Basel II for assessing the capital requirement as also the capital adequacy of each bank vis-à-vis its risk profile and the standard of its internal controls system and risk management practices. The maintenance of financial stability has been explicitly recognised as a key objective by the Reserve Bank in various policy documents. The Reserve Bank has also set up a Financial Stability Unit as announced in the Annual Policy Statement for 2009-10, for carrying out periodic stress testing and for preparing financial stability reports.

References:

1. European Union (2009), Report of The High Level Group on Financial Supervision in the EU, (Chairman: Jacques de Larosiere), February 25.

2. G20 (2009), Report of the Group on Enhancing Sound Regulation and Strengthening Transparency, (Chairman: Dr. Rakesh Mohan), March.

3. Government of India and Reserve Bank of India (2009), Report of the Committee on Financial Sector Assessment, (Chairman: Dr. Rakesh Mohan), March.

4. Reserve Bank of India (2008), Report on Currency and Finance, 2006-08, September.

MACRO-PRUDENTIAL INDICATORS REVIEW

VI.94 The compilation and review of macro prudential indicators (MPIs) was done on a semi­annual basis since March 2000. The review, placed before the BFS, covers analysis of macroeconomic aggregates and financials of commercial banks, NBFCs, UCBs, AIFIs, PDs, RRBs, and co-operative banks, on the CAMELS framework. Recently, as directed by the BFS, the frequency of MPI compilation was changed from semi-annual to quarterly and the coverage of the review was expanded to include assessment of banks’ vulnerability, financials of systemically important NBFCs and other key parameters to make it more relevant to the changing needs of effective surveillance of the financial system. The quarterly review of MPI is supplemented by the preparation of a monthly banking system outlook incorporating balance sheet analysis of SCBs along with high-frequency market data and macroeconomic data. The broad structure of the revised quarterly MPI review covers assessment of macroeconomic indicators, outlook for banks and other financial intermediaries impacting their credit/market/liquidity risk, resilience of banks and other financial intermediaries to plausible stress scenarios, analysis of their financials, and assessment of financial stability in the light of the macroeconomic indicators and institutions’ risk profile.

VI.95 An overview of MPIs for 2008-09 indicates deterioration in a few indicators but improvement in efficiency of the major constituents of the financial sector (Table 6.8). The crisis adversely impacted all the segments of the financial markets where banks actively operate, viz., credit market, money market, foreign exchange market, equity market and bond market. The key performance analysis for the SCBs during 2008-09 under four broad parameters, viz., business growth, capital adequacy, asset quality and profitability suggest that while growth in business moderated, the other critical financial soundness measures continued to remain stable and comfortable.

Capital Adequacy

VI.96 The CRARs of the SCBs continue to be well above the prescribed minimum level of 9.0 per cent (Table 6.9). In fact, the core (Tier I) CRAR of SCBs itself was 9.0 per cent at end-March 2009 (almost the same as at end-March 2008), which indicates a high proportion of better quality capital in the CRAR for the Indian banking system. There still remains significant headroom, though, for banks to raise additional upper and lower Tier II capital. The CRAR of scheduled UCBs at end-March 2009 was higher than that at end-March 2008 (refer Table 6.8). Out of 53 scheduled UCBs, the CRARs of 43 UCBs were 9 per cent and above, while of 8 UCBs were less than 3 per cent.

VI.97 The CRAR of FIs as a group decreased during 2008-09 (Table 6.10). This was mainly due to the decrease in the CRAR of refinancing institutions. Though the CRAR of NBFCs as a group decreased between end-March 2008 and end-September 2008, it continued to remain above the regulatory minimum of 12 per cent. While companies having CRAR less than 12 per cent declined both in absolute and percentage terms during the period, there was also a marginal decline in percentage terms of companies with CRAR exceeding 30 per cent (Chart VI.2). The CRAR of primary dealers also declined during 2008-09 but remained higher than regulatory minimum.

Asset Quality

VI.98 Gross NPAs as percentage of gross advances of SCBs and the net NPA ratio remained virtually unchanged during 2008-09 (Table 6.11). There has, however, been a significant rise in this ratio for foreign banks and new private sector banks, particularly after September 2008, reflecting deterioration in the asset quality of these bank groups following the global financial meltdown. Since, in absolute terms, both gross and net NPAs increased during 2008-09 despite extension of certain relaxations permitted to banks to restructure certain advances, banks need to exercise better risk management and vigil to avoid future slippage in asset quality. Net NPAs of nine banks were in excess of 2 per cent of net advances in 2008-09 (Table 6.12). Asset quality of scheduled UCBs continued to improve during the year. Out of the 53 scheduled UCBs, net NPA ratios of 44 were 5 per cent or less (Table 6.13).

Earnings and Profitability Indicators

VI.99 While the cost of deposits and cost of funds for all bank groups increased in 2008-09, the return on advances and return on funds also registered an increase (Table 6.14).

VI.100 In terms of measures of profitability, the performance of SCBs was not affected by the economic slowdown as the RoA of SCBs was higher during 2008-09, than last fiscal year (Table 6.15). The non-interest income of SCBs increased by nearly 25 per cent. The increase in income more than offset the increase in expenditure such that profits before provisions and taxes (as per cent to total assets) also registered an increase during the year. Out of a total of 79 banks, 55 registered an increase in earnings before provisions and taxes while 37 recorded an increase in return on assets during the year (Table 6.16). The return on total assets of scheduled UCBs increased during 2008-09 (Table 6.17).

Sensitivity to Market Risk

Interest Rate Risk

VI.101 Interest rate risk faced by the banks as at end-March 2009, though subdued due to a higher proportion of held-to-maturity (HTM) portfolio in total investments, still poses some risk due to widening spreads between short-term and long-term yields and because the HTM portfolios generally have higher duration bonds. Though sovereign yields have been declining, expectations of large fiscal deficit and inflationary pressures are reversing the decline. The AIFIs are vulnerable to interest rate risk as they have a large part of their assets as investment in government securities and the cushion available to them to absorb losses due to rise in interest rate is limited.

Currency Risk

VI.102 Till the end of last quarter of financial year 2008-09, slowdown in exports, deterioration in the current account balance and weakening crude oil continued to weaken the rupee. Due to their nominal foreign currency exposure, commercial banks are not exposed to currency risk. Moreover, they also have lower overnight positions. The present outlook shows that the resilience of the Indian economy amidst the global crisis is attracting FDI inflows coupled with equity market opportunities. This has the positive effect of arresting the depreciation in the rupee. The unhedged foreign currency exposures of banks on behalf of their clients may pose currency risk, which needs to be monitored.

Credit Risk

VI.103 As crunch persisted in other fronts of funding, commercial sectors continued to look for domestic credit supply. Accelerated steps such as cuts in policy rates, relaxation in prudential norms, restructuring and moral persuasion by the Reserve Bank enabled the commercial banks to lend more. However, this has also raised concerns of credit risk and could affect bank’s asset quality. As at end-March 2009, banks’  off-balance sheet exposures had come down as percentage of total balance sheet assets and in terms of notional principal amount accounted for marginally more than two times of their total on balance sheet assets. This is a significant decline when compared with the figure of more than four times in June 2008. Majority of the derivatives are over the counter deals and largely concentrated among a few foreign banks.

Liquidity Risk

VI.104 When compared with the first three quarters of 2008-09, the last quarter saw some easing on the liquidity front enabled by the Reserve Bank’s series of monetary easing and liquidity enhancing measures. Despite the additional pressure on demand for bank credit, commercial banks preferred to tread cautiously and maintain liquidity on hand. The banking system has come back to surplus mode since last quarter. Large demand for long-term credit by the real and infrastructure sectors hardens liquidity management of banks. Continued recessionary   conditions also creates more funding and timing risk. Funding risk arises due to unexpected withdrawal of deposits, especially wholesale deposits. Liquidity timing risk could arise when expected cash inflows falter. This calls for diligent liquidity management by commercial banks despite being in surplus mode at present.

VI.105 The effectiveness of the Reserve Bank’s regulatory and supervisory structure in dealing with a major contagion from a severe global crisis was tested in 2008-09. All financial soundness indicators for the Indian banking system, however, exhibited signs of stability and strength at the end of March 2009. Not only did every bank remain above the minimum regulatory capital requirement but even the quality of capital was high, which is evident from the fact that Tier I capital alone was at 9.0 per cent for the banking system. Gross NPAs as percentage of gross advances has not deteriorated, while profitability indicators (i.e., RoE and RoA) further improved during 2008-09. Stress test results also revealed that Indian banks could withstand probable extreme shocks. The comprehensive self-assessment was conducted by the CFSA at a time when a relook at the Indian regulatory architecture was necessary in the context of the global financial crisis. The findings of the Committee corroborated the resilience of the Indian banking system to withstand extreme shocks.

VI.106 The main factors responsible for this endurance in the financial system were the robust regulatory regime in place and an effective supervisory mechanism. While assessing the safety, soundness and solvency of banks, the risk profile and systemic risk potential of banks, both at the individual and sector level are also assessed. Any symptom of build-up of large imbalances across institutions/different economic segments/ sectors as also perception of risks which could escalate into a contagion are dealt with appropriately by enhancing the rigorousness of available prudential and other regulatory and supervisory measures. Several measures such as enhanced provisions, risk weights, targeted appraisals, special supervisory review along with regulatory restrictions and penalties are resorted to, as and when considered necessary. A system of Prompt Corrective Action (PCA), based on three parameters viz., CRAR, net NPAs and RoA is in place.

VI.107 When the crisis reached a flashpoint in September 2008, besides meeting the liquidity needs of the banking system through provision of both domestic and foreign currency liquidity, the Reserve Bank also prudently changed the counter­cyclical risk weights, provisioning requirements and asset classification norms for restructured assets, all of which created enabling conditions for preventing sharp moderation in credit growth during the economic slowdown. NBFCs, mutual funds and finance companies experienced some liquidity stress, which was carefully examined by the Reserve Bank. Contrary to the initial perception, it turned out that liquidity problems were confined to only a small section of NBFCs. The problem was swiftly addressed by the Reserve Bank through appropriate liquidity enhancing measures. With a view to preserving and further strengthening the regulatory and supervisory architecture, the Reserve Bank would constantly review the lessons from the global financial crisis, as also the emerging views in the context of Basel II framework relating to procyclicality, risk coverage, quality of bank capital, credit ratings, stress tests, management of liquidity and other emerging issues relating to cross-border supervision and supervisory cooperation, monitoring of large and complex banks and enhancing the scope of regulation and supervision for systemic stability. As on March 31, 2009 all Indian banks, including the foreign banks, had migrated to the Basel II simpler approaches,and as such they will be subject to the SREP under Pillar 2 of Basel II for assessing the capital requirement as also the capital adequacy of each bank vis-a-vis its risk profile and the standard of its internal control system and risk management practices.

¹ Including Bank International Indonesia, which ceased operations in India and is being wound up.

² This excludes Lehman Brothers Fixed Income Securities Ltd., which was prohibited from undertaking primary market operations with effect from September 16, 2008.

³ Based on data from 68 Countries - "Report of the Committee on Financial Sector Assessment (2009), constituted by Government of India, March, Vol. III, page 309".