V.1 During 2006-07, the Reserve Bank continued to focus its regulatory and supervisory initiatives on promoting a stable and competitive financial sector in an environment characterised by rising globalisation, ongoing financial deregulation and rapid technological innovations. Prudential, accounting and disclosure norms were strengthened so as to promote financial stability. Consistent with the policy approach of conforming the domestic financial sector to the international best standards with emphasis on gradual harmonisation, final guidelines for implementation of the New Capital Adequacy Framework (Basel II) by banks were issued. Initiatives to strengthen the urban cooperative banks were pursued during the year, following the path set out in the draft Vision Document. In view of the important role played by the non-banking financial companies in broadening access to financial services, enhancing competition and diversification of the financial sector, the Reserve Bank continued with its efforts to strengthen these entities. The Reserve Bank also focused on the initiatives for protecting customers’ rights, enhancing the quality of customer service and strengthening the grievance redressal mechanism in banks during 2006-07.

V.2 In the above backdrop, this Chapter details the various regulatory and supervisory measures initiated by the Reserve Bank relating to banks and other financial institutions during 2006-07. The supervisory review process (SRP) undertaken with respect to select banks having significant exposure to the sensitive sectors revealed that real estate exposure increased across banks, mainly on account of individual housing loans. The prudential norms were strengthened, especially in view of rapid credit growth in various sectors. The smooth migration to the Basel II framework continued to engage the attention of the Reserve Bank as commercial banks in India would start implementing Basel II norms from March 31, 2008. A ‘Code of Banks’ Commitment to Customers’ was released to provide a framework for a minimum standard for banking services which individual customers can legitimately expect. As a part of the gradual process of financial liberalisation, it is considered appropriate to introduce credit derivatives in a calibrated manner. In the context of the recent amendment to the Reserve Bank of India Act, 1934 providing legality to OTC derivative instruments, including credit derivatives, it was proposed in the Annual Policy Statement for the Year 2007-08 to permit banks and PDs to begin transacting in single-entity credit default swaps. Given the significant role played by urban cooperative banks in providing banking services to the middle/lower middle income people, initiatives were also undertaken to strengthen these banks. Following the path set out in the draft Vision Document, Memoranda of Understanding (MoU) have been signed with the 12 States and the Task Force for Co-operative Urban Banks (TAFCUBs) have also been constituted in these States. UCBs in States, which have signed MoUs, have been enabled to expand their business by allowing them to set up currency chests, sell mutual fund products, provide foreign exchange services, open new ATMs and convert extension counters into branches. The MoUs have also been signed between the Reserve Bank and the Central Government in respect of Multi-State UCBs. Almost 83 per cent of the UCBs accounting for about 90 per cent of the total deposits are covered under the MoU arrangements. The regulatory framework with regard to systemically important non-banking financial companies was strengthened to reduce regulatory gaps. Systemically important non-deposit taking NBFCs were also defined and prudential norms were specified for these entities.

REGULATORY FRAMEWORK FOR THE INDIAN

FINANCIAL SYSTEM

V.3 The Reserve Bank performs regulatory and supervisory role over commercial and urban co-operative banks (UCBs), financial institutions, non-banking financial companies (NBFCs) and primary dealers (PDs) through the Board for Financial Supervision (BFS).  As at end-March 2007, there were 82 commercial banks [excluding regional rural banks (RRBs)] (of which nine were permitted to undertake PD business), 96 RRBs, 1,815 UCBs, 7 development finance institutions (DFIs), 13,020 NBFCs (of which 403 NBFCs are permitted to accept/hold public deposits) and 11 PDs. The BFS continued to exercise its supervisory role over the segments of the financial system that are under the purview of the Reserve Bank. The BFS is headed by the Governor with a Deputy Governor as Vice Chairperson and other Deputy Governors and four Directors of the Central Board as members. In respect of the State and district central co-operative banks, and RRBs, while the Reserve Bank is the regulator, the supervision is vested with the National Bank for Agriculture and Rural Development (NABARD). Insurance companies and mutual funds are regulated by the Insurance Regulatory and Development Authority (IRDA) and the Securities and Exchange Board of India (SEBI), respectively. A coordinated approach to supervision is ensured through a High-Level Coordination Committee on Financial and Capital Markets (HLCCFM) with the Governor of the Reserve Bank, as Chairman, and the chiefs of the SEBI, the IRDA and the Pension Fund Regulatory and Development Authority (PFRDA), and the Secretary, Economic Affairs, Ministry of Finance, Government of India as the members.  During 2006-07, two meetings of the HLCCFM were held on July 28, 2006 and March 8, 2007. During 2007-08, so far one meeting of the HLCCFM was held on July 19, 2007.

V.4 During 2006-07, the BFS provided guidance on several regulatory and supervisory policy decisions, with particular attention to issues arising out of the increasing complexity of the financial system, the impending implementation of the New Capital Adequacy Framework (Basel II) in India, banks’ exposure to sensitive sectors, risk management and corporate governance. The following are some of the major issues addressed under the guidance of the BFS during the year. First, the second round of supervisory review process (SRP) with regard to banks’ exposures to sensitive sectors was initiated for select banks, based on off-site data (Box V.1).

V.5 Second, recognising the risk facing banks due to their exposures to the real estate sector, provisioning requirements and risk weights on real estate exposures were tightened.

V.6 Third, as some of the banks were found to be using floating provisions to set-off against provisions required to be made as per extant prudential guidelines which resulted in smoothening of profits, detailed guidelines were issued to banks.  The guidelines stipulated, inter alia, that floating provisions can be used only for contingencies under extraordinary circumstances for making specific provisions in impaired accounts after obtaining Board’s approval and with prior permission of the Reserve Bank.  To enable banks’ Boards to evolve suitable policies in this regard, it was clarified that the extra-ordinary circumstances refer to losses which do not arise in the normal course of business and which are exceptional and non-recurring in nature and could be broadly classified under three categories, viz., general, market and credit.

V.7 Fourth, in order to capture the vast and significant changes taking place in the banking sector, the supervisory rating model based on CAMELS/ CALCS used for the purpose of rating the commercial banks in India during the Annual Financial Inspection (AFI) was revised comprehensively to ensure greater objectivity in assessment by introducing benchmarks based on industry averages/frequency distributions. It was also decided that the rating model would be assessed for its viability and effectiveness on an ongoing basis and updated regularly to factor in the evolving dynamics and requirements to reflect the most objective scenario.

Box V.1
Supervisory Review Process

The Mid-term Review of the Annual Policy Statement 2005-06 had stated that supervisory review process (SRP) would be initiated in respect of select banks having significant exposure to real estate sector, highly leveraged NBFCs, venture capital funds and capital markets, in order to ensure that effective risk mitigants and sound internal control are in place.

In the first round, a framework was developed for monitoring systemically important individual banks. In the second round of the SRP, undertaken in January-March 2007, the exposure of select banks to sensitive sectors, particularly to the real estate sector was analysed. Ten banks with real estate exposure and capital market exposure in excess of 200 per cent and 25 per cent, respectively, of their net worth were identified. The second round of the SRP was split into two phases. Under Phase I, detailed information on exposure to sensitive sectors, including real estate sector as per the revised definition, was sourced from these banks, followed by discussions with their senior officials. Phase II of the SRP was based on onsite focused examination to assess the risk exposures of individual banks with reference to their actual control environment, procedures, and compliance with internal and regulatory norms. The onsite scrutiny focused on large lending towards real estate and other sensitive sectors, companies involved, branch-wise large individual exposures, and other related matters.

The initial analysis revealed that real estate exposure increased across all the banks, mainly on account of individual housing loans. Commercial real estate exposure had also risen in varying degrees across all the banks. Although exposure to the capital market showed an increasing trend, none of the banks breached the regulatory limits. Exposure to the highly leveraged NBFCs was found to be minimal in most of the identified banks and wherever banks had exposures, a majority of them were in the public sector. The analysis also revealed that, prima facie, all the banks under review had some risk management policies, systems and controls in place to tackle the risks posed by exposure to sensitive sectors. However, in the case of the real estate exposure, certain lapses were observed with regard to implementation of banks’ own approved policies.

V.8 Finally, all the NBFCs were advised to  submit a certificate from their statutory auditors every year to the effect that they continue to undertake the business of a non-banking financial institution (NBFI) requiring holding of  the certificate of registration (CoR) under Section 45-IA of the Reserve Bank of India Act, 1934.

REGULATORY AND SUPERVISORY INITIATIVES

Commercial Banks

V.9 As part of the ongoing efforts to strengthen the banking system through the adoption of policies aimed at both improving the financial strength of banks as well as bringing about greater transparency in their operations, several policy measures were initiated during 2006-07.

Strengthening Prudential Norms

V.10 Bank credit has recorded sustained high growth since 2003-04, with non-food credit by scheduled commercial banks recording an annual average growth of about 30 per cent per annum during 2004-05 to 2006-07. Banks’ loans and advances por tfolios are pro-cyclical and concomitantly, there is a tendency to underestimate the level of inherent risk during times of accelerated credit growth. In order to ensure that asset quality is maintained in the light of high credit growth and taking into account the rise in default rates with regard to personal loans and credit card receivables, the general provisioning requirement for standard advances by banks in specific sectors, i.e., personal loans, loans and advances qualifying as capital market exposures, residential housing loans beyond Rs.20 lakh, commercial real estate loans and loans to non-deposit taking systemically important NBFCs were raised in May 2006/January 2007 (Table 5.1). As hitherto, these provisions would be eligible for inclusion in Tier II capital for capital adequacy purposes to the permitted extent. The revised provisioning requirements are also applicable to the urban cooperative banks (UCBs).

V.11 Implementation of infrastructure projects can get delayed due to a variety of factors beyond the control of the promoters, requiring restructuring/ reschedulement by the banks. Accordingly, asset classification norms for infrastructure projects were modified with effect from March 31, 2007. Consequently, infrastructure projects would be treated as sub-standard if the date of commencement of commercial production extended beyond a period of one year  after the originally envisaged date of completion of the project, as against the earlier stipulation of six months.

V.12 Banks (including UCBs) were advised (November 2006) to strictly comply with the directions of the Monitoring Committee constituted by the High Court of Delhi regarding unauthorised construction, misuse of properties and encroachment on public land, while extending housing loans for building construction as well as for purchase of constructed property/built up property.

Risk Management

V.13 Keeping in view the market conditions, effective September 20, 2006, banks’ exposure to entities for setting up the Special Economic Zones (SEZs) or for acquisition of units in the SEZs which included real estate are treated as exposure to the commercial real estate sector.

V.14 Banks are increasingly relying on outsourcing as a means of reducing costs as well as accessing external expertise. At the same time, outsourcing is associated with certain risks, viz., strategic risk, reputation risk, compliance risk, operational risk, exit strategy risk, counterparty risk, country risk, contractual risk, access risk, concentration risk and systemic risk. The failure to manage these risks could lead to financial losses/reputational risk for the bank and systemic risks within the banking system. Accordingly, based on suggestions received on the draft guidelines issued in December 2005, the final guidelines were issued in November 2006.  These guidelines are concerned with managing risks in outsourcing of financial services and are not applicable to technology-related issues and activities not related to banking services like usage of courier, catering of staff, housekeeping and janitorial services, security of the premises, movement and archiving of records. Banks, which desire to outsource financial services, would not require prior approval from the Reserve Bank, whether the service provider is located in or outside India.

V.15 An Internal Group was constituted by the Reserve Bank to review the existing guidelines on derivatives and formulate comprehensive guidelines on derivatives. Based on the Group’s report, comprehensive guidelines on derivatives were issued on April 20, 2007. These guidelines relate to rupee interest rate derivatives and cover broad generic principles for undertaking derivative transactions, management of risk and sound corporate governance requirements and detailed guidance on suitability and appropriateness policy to be adopted by market makers. Guidelines in respect of foreign exchange derivatives will be issued separately. As a part of the gradual process of financial liberalisation, it is considered appropriate to introduce credit derivatives in a calibrated manner. In the context of the recent amendment to the Reserve Bank of India Act, 1934 providing legality of OTC derivative instruments, including credit derivatives, it was proposed in the Annual Policy Statement of the Reserve Bank in April 2007 to permit banks and PDs to begin transacting in single-entity credit default swaps. In this context, draft guidelines on credit default swaps were issued in May 2007.

V.16 Venture capital funds (VCFs) play an important role in encouraging entrepreneurship; however, the absence of adequate public disclosures with regard to their performance/asset quality can raise risks inherent in banks’ exposure to VCFs. The prudential framework governing banks’ exposure to VCFs was revised in August 2006. Under the revised framework, banks’ exposures to VCFs (both registered and unregistered) are deemed to be on par with equity and hence reckoned for compliance with the capital market exposure ceilings (ceiling for direct investment in equity and equity linked instruments as well as ceiling for overall capital market exposure). The quoted equity shares/bonds/units of VCFs in the banks’ portfolio shall be held under the ‘available for sale’ (AFS) category and shall be marked to market, preferably on a daily basis, but at least on a weekly basis in line with valuation norms for other equity shares. Banks’ investments in unquoted shares/ bonds/units of VCFs made after issuance of these guidelines shall be classified under the ‘held to maturity’ (HTM) category for an initial period of three years, and shall be valued at cost. For the investments made before the issuance of these guidelines, the classification shall be done as per the existing norms. After three years, the unquoted units/shares/bonds shall be transferred to the AFS category and shall be valued according to the guidelines. Investments in shares/units/bonds of VCFs shall be assigned 150 per cent risk weight for measuring the credit risk during the first three years when these are held under the HTM category. When these are held under or transferred to the AFS, the capital charge for the specific risk component of the market risk (as required in terms of the present guidelines on computation of capital charge for market risk), shall be fixed at 13.5 per cent to reflect the risk weight of 150 per cent. The charge for general market risk component shall be at 9 per cent for investments in shares/units, as in the case of other equities. For investments in bonds, the charge for general market risk shall be computed as in the case of investment in any other kind of bonds. The exposures to VCFs other than investments shall also be assigned a risk weight of 150 per cent. The entire investment in VCFs will be outside the purview of guidelines relating to non-SLR securities.

V.17 Guidelines on banks’ exposure to capital markets were rationalised in terms of base and coverage in April 2007.  Under the extant norms, banks’ aggregate exposure to the capital market in all forms was restricted to five per cent of their total outstanding advances (including commercial paper) as on March 31 of the previous year. Within this overall ceiling, banks’ direct investments in shares, convertible bonds/debentures and units of equity-oriented mutual funds were restricted to 20 per cent of their net worth. On a consolidated basis, banks’ aggregate exposure to capital market was subject to the overall ceiling of two the per cent of their total on-balance-sheet assets (excluding intangible assets and accumulated losses) as on March 31 of the previous year, within which their investments in shares, convertible bonds/debentures and units of equity oriented mutual funds were restricted to 10 per cent of their consolidated net worth. In terms of the revised guidelines, aggregate exposure of a bank on solo as well as on consolidated basis to the capital markets in all forms (both fund and non-fund based) should not exceed 40 per cent of its net worth (consolidated net wor th in the case of consolidated bank) as on March 31 of the previous year. Within this overall ceiling, direct investment in shares, convertible bonds/debentures, units of equity-oriented mutual funds and all exposures to VCFs (both registered and unregistered) should not exceed 20 per cent of the bank’s net worth/consolidated net worth.

V.18 From the perspective of financial stability, the concentration risk on the liability side of banks is as important as that on the asset side. While the counterparty risk concentration on the assets side has attracted adequate attention and received regulatory policy response, the concentrated risk on the liability side of the banks has not received similar attention. Uncontrolled liabilities, in particular inter-bank liabilities, may have systemic implications, even if the individual counterparty banks are within the allocated exposure. In order to reduce the extent of concentration on the liability side of banks, the Reserve Bank put in place a comprehensive framework of liability management in March 2007. Accordingly, banks were advised to fix, with the approval of their boards of directors, a limit for their inter-bank liabilities within the prudential limit of 200 per cent of their net worth, based on their audited balance sheet as on March 31 of the previous year. Banks with CRAR of more than 11.25 per cent are allowed to have an additional limit of 100 percentage points, i.e., up to 300 per cent of the net worth. The limit so fixed will include only fund based inter-bank liabilities. Since the limits are for inter-bank borrowings within India, inter-bank borrowings/ liabilities outside would be excluded.  Collateralised borrowings under the CBLO and refinance from NABARD and SIDBI would also be excluded.  The existing limit on the call money borrowings prescribed by the Reserve Bank would operate as a sub-limit within the above limits.

Accounting and Disclosure Norms

V.19 In order to ensure that the drawdown by banks of their statutory reserves is done prudently and is not in violation of any of the regulatory prescriptions, banks were advised (September 2006) (i) to take prior approval from the Reserve Bank before any appropriation is made from the statutory reserve or any other reserves; (ii) all expenses including provisions and write-offs recognised in a period, whether mandatory or prudential, should be reflected in the profit and loss account for the period as an ‘above the line’ item (i.e., before arriving at the net profit); (iii) wherever draw down from reserves takes place with the prior approval of the Reserve Bank, it should be effected only ‘below the line’ (i.e., after arriving at the profit/loss for the year); and (iv) to ensure that suitable disclosures are made of such draw down of reserves in the ‘notes on accounts’ to the balance sheet.

V.20 In March 2003, banks were advised to adopt the three business segments, viz., ‘treasury’, ‘other banking business’ and ‘residual’ as the uniform business segments, and ‘domestic’ and ‘international’ as the uniform geographic segments, for the purpose of segment reporting under the Accounting Standard (AS) 17. However, the ‘other banking business’ segment was found to very broad, containing almost the entire banking book. In order to enhance transparency, banks were advised in April 2007 to divide this segment into three categories, viz., corporate/wholesale banking, retail banking and other banking operations. The disclosure requirement will come into force from the reporting period ending March 31, 2008. The retail banking has been defined keeping in view the criteria of orientation, product, granularity, and low value of individual exposures. Individual housing loans will also be included in the retail banking segment. Wholesale banking would include all advances to trusts, partnership firms, companies and statutory bodies, not included under retail banking.

V.21 Disclosure of information in the public interest by the employees of an organisation is increasingly gaining acceptance by public bodies for ensuring better governance standards and probity/ transparency in the conduct of affairs of public institutions. Accordingly, as a proactive measure to strengthen financial stability and to enhance public confidence in the financial sector, the Reserve Bank introduced the ‘protected disclosures scheme for the private sector and foreign banks’ on April 18, 2007. The scheme is broadly on the lines of the Government of India Resolution of April 2004 which is applicable to the public sector banks as well as the Reserve Bank (Box V.2).

Resolution of Non-Performing Loans

V.22 In order to facilitate recovery of their assets, banks have been provided with a number of avenues. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act, 2002), inter alia, seeks to regulate securitisation and reconstruction of financial assets and enforcement of security interest for realisation of dues without the intervention of courts or tribunals. The Act enables banks and financial institutions (FIs) to realise long term assets, improve recovery by exercising powers to take possession of securities and sell them and reduce non-performing assets by adopting measures for recovery or reconstruction. Under the Act, commercial banks issued 193,887 notices up to March 31, 2007, involving an outstanding amount of Rs.44,214 crore. Of this, an amount of Rs.10,909 crore was recovered from 106,692 cases, while Rs.6,512 crore was received through 46,461 compromise proposals.

V.23 The Recovery of Debts Due to Banks and Financial Institutions Act, 1993 provides for the establishment of tribunals for the expeditious adjudication and recovery of debts owed to banks and FIs. The amendments made in 2000 and 2003 to the Act and the Rules framed thereunder have strengthened the functioning of the Debt Recovery Tribunals (DRTs). Out of 75,441 cases involving Rs.1,20,559 crore filed with the DRTs by the banks, 41,410 cases involving Rs.53,639 crore were adjudicated by end-March 2007. The amount recovered through the adjudicated cases was Rs.18,521 crore.

V.24 Commercial banks and FIs can also use the forum of Lok Adalats to reduce the stock of NPAs. While Lok Adalats organised by the Civil Courts can settle banking disputes involving an amount up to Rs.20 lakh, those convened by the various DRTs/Debt Recovery (Appellate) Tribunals (DRATs) can  resolve cases involving Rs 10 lakh and above.  At end-March 2007, the number of cases filed by commercial banks with Lok Adalats stood at 976,101 involving an amount of Rs.5,833 crore. Of this, 352,302 cases involving an amount of Rs.1,772 crore have been decided. An amount of Rs.759 crore has been recovered from 283,401 cases.

Anti-Money Laundering

V.25 Detailed guidelines based on the recommendations of the Financial Action Task Force (FATF) on Anti-Money Laundering Standards and on Combating Financing of Terrorism were issued to banks in November 2004 to formulate and put in place a proper policy framework on ‘Know Your Customer’ and Anti-Money Laundering (ALM) measures. With a view to implementing Special Recommendation VII (SR VII) of the FATF, which aims at preventing terrorists and other criminals from having unfettered access to wire transfers for moving their funds, the Reserve Bank advised banks in April 2007 that domestic wire transfers of Rs.50,000 and above and all cross-border wire transfers should be accompanied by accurate and meaningful originator information (name, address and account number) which should be retained throughout the payment chain. Furthermore, the record of originator information accompanying a wire transfer should be kept for ten years, as required under the Prevention of Money Laundering Act (PMLA), 2002. The beneficiary banks should also put in place effective risk-based procedures in order to identify wire transfers that lack complete originator’s information. In case, any overseas ordering bank/financial institution fails to furnish information on the remitter, the receiving bank should restrict or even terminate its business relationship with the ordering bank.

Box V.2
Protected Disclosures Scheme for Private Sector and Foreign Banks

Globally, large scale corporate frauds have necessitated various legislative measures for safeguarding public interest, through enactments such as the Whistleblower Protection Act in the US and the Public Interest Disclosure Act in the UK.  In the Indian context, the Government of India had authorised, on April 21, 2004, the Central Vigilance Commission (CVC) as the ‘designated agency’ to receive written complaints or disclosure on any allegation of corruption or of misuse of office and recommend appropriate action. The jurisdiction of the CVC in this regard is restricted to employees of the Central Government or of any corporation established by it under any Central Act, Government companies, societies or local authorities owned or controlled by the Central Government. Thus, the Government of India scheme covers the public sector banks and the Reserve Bank (since it is an entity established under the Central statute).

The Reserve Bank introduced a similar scheme on April 18, 2007, applicable to private sector and foreign banks operating in India. The complaints under the scheme would cover areas such as corruption, misuse of office, criminal offences, suspected/actual fraud, failure to comply with existing rules and regulations, and acts resulting in financial loss/operational risk, loss of reputation, and detrimental to depositors’ interest/public interest. Under the scheme, employees of the bank concerned (private sector and foreign banks operating in India), customers, stakeholders, NGOs and members of public can lodge complaints.

Towards More Deregulation

V.26 In order to facilitate the expansion of Indian corporates’ business abroad, the prudential limit on credit and non-credit facilities extended by banks to Indian joint ventures (where the holding by the Indian company is more than 51 per cent)/wholly owned subsidiaries abroad was enhanced from 10 per cent to 20 per cent of their unimpaired capital funds (Tier I and II capital) in November 2006.

Opening up of the Financial Sector

V.27 During 2006-07, Indian banks continued to expand their presence overseas (Table 5.2). As at end-June 2007, 16 banks (11 public sector banks and 5 private sector banks) had a network of 188 offices (123 branches, 38 representative offices, 7 joint ventures and 20 subsidiaries) overseas.

V.28 During the calendar year 2006, the Reserve Bank issued approvals for opening 13 branches of foreign banks in India. During 2006-07 (July 2006-June 2007), permission was granted to three existing foreign banks to open 10 branches in India,  to six foreign banks to open one representative office each in Mumbai and to one foreign bank to open a representative office in New Delhi. During the same period, six foreign banks have opened their branches across India and four foreign banks have opened their representative offices in Mumbai (Table 5.3).  As at end-June 2007, 29 foreign banks were operating in India with 268 branches.  In addition, 34 foreign banks were also operating in India through their representative offices.

Mergers and Amalgamations

V.29 In view of the deteriorating financial condition of the Ganesh Bank of Kurundwad Ltd. (GBK), the Government of India, on the recommendation the Reserve Bank, placed the bank under an Order of

Moratorium for a period of three months with effect from the close of business on January 7, 2006. During the period of moratorium, based on a

proposal received from the Federal Bank Ltd., the Reserve Bank prepared a draft Scheme of Amalgamation of GBK with the Federal Bank Ltd. The objections/suggestions received on the draft Scheme were considered by the Reserve Bank. With the Reserve Bank having complied with all the statutory requirements under Section 45 of the Banking Regulation Act, 1949, the Government of India sanctioned the said scheme and the Scheme of Amalgamation came into force on January 25, 2006. However, the amalgamation was challenged by GBK and others before the High Court of Bombay and thereafter before the Supreme Court. The Supreme Court dismissed the special leave petition on August 28, 2006. Following this, the Government issued necessary notification on September 1, 2006 and GBK was amalgamated with the Federal Bank Ltd. with effect from September 2, 2006.

V.30 In view of the deteriorating financial condition of the United Western Bank Ltd. (UWB), the Government of India, on an application made by the Reserve Bank, issued an Order of Moratorium under sub Section (2) of Section 45 of the Banking Regulation Act, 1949, on the bank for a period of three months effective September 2, 2006. During the period of moratorium, the Reserve Bank received expression of interest for amalgamation from 17 entities. On September 12, 2006, the Reserve Bank placed in public domain a draft scheme of amalgamation of the UWB with the Industrial Development Bank of India (IDBI) Ltd. and invited suggestions/objections on the draft scheme. After considering the objections and suggestions, the Scheme was forwarded to the Government of India for sanction, which was granted on September 30, 2006.  The amalgamation came into force on October 3, 2006.

V.31 ICICI Bank Ltd. and Sangli Bank Ltd. made applications to the Reserve Bank, after obtaining the approval from their shareholders, for sanction of the scheme of amalgamation of Sangli Bank Ltd. with the ICICI Bank Ltd.  The scheme of amalgamation was sanctioned by the Reserve Bank under Section 44 A of the Banking Regulation Act, 1949 and the amalgamation became effective from April 19, 2007.

V.32 The Government of India sanctioned the scheme of Transfer of Undertaking of Bharat Overseas Bank Ltd. to Indian Overseas Bank which was made effective from the close of business on March 31, 2007.

Supervisory Initiatives

V.33 The Basel Committee on Banking Supervision (BCBS) had released the document ‘International Convergence of Capital Measurement and Capital Standard: A Revised Framework’ (popularly known as Basel II framework) on June 26, 2004. With a view to ensuring migration to Basel II in a non-disruptive manner, the Reserve Bank adopted a consultative approach and constituted a Steering Committee comprising senior officers from banks, the Indian Banks’ Association (IBA) and the Reserve Bank. On the basis of the recommendations of the Steering Committee and the sub-groups formed by it, the Reserve Bank had issued draft guidelines for implementation of the new capital adequacy framework for comments in February 2005. The draft guidelines were revised on the basis of the feedback received and reissued for a second round of consultation in March 2007. On the basis of feedback received on the second draft, the guidelines for implementation of the New Capital Adequacy Framework (Revised Framework) were finalised and issued on April 27, 2007 (Box V.3).

V.34 In view of the emergence of financial conglomerates in the country, the supervisory framework is being strengthened (Box V.4). Since the supervision of financial conglomerates is relatively a new concept in the Indian context, the conglomerate supervision framework in place in a couple of countries is being studied to identify the processes and structures of conglomerate supervision which can be replicated in India.

Financial Inclusion

V.35 With a view to achieving the objective of greater financial inclusion, all banks were advised in November 2005 to make available a basic banking ‘no-frills’ account either with ‘nil’ or very low minimum balances as well as charges that would make such accounts accessible to vast sections of population. All the public and the private sector banks as well as foreign banks, except those  not having significant retail presence, are reported to have introduced the basic banking ‘no-frills’ account. Up to end-March 2007, 6.7 million ‘no-frills’ accounts were opened by banks.

V.36 Recognising that Information Technology (IT)-enabled services have the potential for effectively meeting the challenge of providing banking facilities in remote and unbanked areas while keeping the transaction costs low, banks were urged in May 2007 to scale up their financial inclusion efforts by utilising appropriate technology.  Banks were also advised to ensure that the solutions developed are highly secure, amenable to audit and widely accepted open standards to allow inter-operability among the banks. Banks have initiated pilot projects utilising smart cards/mobile technology to increase their outreach.

Box V.3
Basel II - Implementation of the New Capital Adequacy Framework by Banks in India: Salient Features

•   Banks in India shall adopt the Standardised Approach for credit risk, and the Basic Indicator Approach for operational risk for computing their capital requirements under the Revised Framework. Banks shall continue to apply the Standardised Duration Approach for computing capital requirement for market risk.

•   Foreign banks operating in India and Indian banks having operational presence outside India should adopt the Revised Framework with effect from March 31, 2008. All other commercial banks (excluding Local Area Banks and Regional Rural Banks) are encouraged to migrate to the Revised Framework in alignment with them, but in any case not later than March 31, 2009.

•   Banks are required to maintain a minimum capital to risk-weighted assets ratio (CRAR) of 9 per cent on an ongoing basis. However, taking into account the relevant risk factor and internal capital adequacy assessments of each bank, the Reserve Bank may prescribe a higher level of minimum capital ratio to ensure that the capital held by a bank is commensurate with its overall risk profile.

•   Banks are required to maintain, at both solo and consolidated level, a minimum Tier I ratio of at least 6 per cent. Banks below this level must achieve this ratio on or before March 31, 2010.

•   The minimum capital maintained by banks on implementation of Basel II norms shall be subject to a prudential floor computed with reference to the requirement as per Basel I framework for credit and market risks. The floor has been fixed at 100 per cent, 90 per cent and 80 per cent for the position as at end-March for the first three years of implementation of the Revised Framework.

•   With a view to ensuring smooth transition to the Revised Framework and providing opportunity to banks to streamline their systems and strategies, banks were advised to have a parallel run of the Revised Framework.

•   Banks may use the credit ratings awarded by the following four credit rating agencies for assigning risk weights for credit risk for capital adequacy purposes: Credit Analysis and Research Ltd., CRISIL Ltd., Fitch India, and ICRA Ltd. Banks are also allowed to use the credit ratings of following three international rating agencies: Fitch, Moody’s and Standard & Poor’s.

•   Claims on domestic sovereigns (Central and State Governments) will attract a zero risk weight while those guaranteed by State Governments will attract 20 per cent risk weight.

•   Risk weights for claims on banks will be linked to the capital adequacy position of the counter party bank. Scheduled and other banks will receive a differential treatment.

•   Claims on corporates will be risk weighted as per the ratings awarded by the chosen rating agencies. Unrated claims on corporates will attract a risk weight of 100 per cent.  Claims above Rs.50 crore sanctioned/renewed on or after April 1, 2008 will attract a higher risk weight of 150 per cent; this threshold will be lowered to Rs.10 crore with effect from April 1, 2009.

•   Claims eligible for inclusion as regulatory retail portfolio, specified claims secured by mortgage of residential property, loans and advances to banks’ own staff meeting the specified conditions, and consumption loans up to Rs.1 lakh against gold and silver ornaments shall attract a preferential risk weight ranging between 20 per cent and 75 per cent.

•   Claims in respect of a few specified categories such as venture capital funds, commercial real estate, consumer credit including personal loans and credit card receivables, capital market exposures, and claims on non-deposit taking systemically important NBFCs will attract risk weights of 125 per cent or 150 per cent.

•   Capital requirements for operational risk under the Basic Indicator Approach will be the average of a fixed percentage of positive annual gross income of the previous three completed financial years.

•   A set of disclosure requirements has been prescribed to encourage market discipline.

•   Banks are required to obtain prior approval of the Reserve Bank to migrate to the advanced approaches such as the Internal Rating Based Approach for credit risk and the Standardised Approach or the Advanced Measurement Approach for operational risk for computing capital requirements. The pre-requisites and procedure for approaching the Reserve Bank for seeking such approval will be issued in due course.

V.37 In February 2007, banks were permitted to prepare a scheme for offering ‘doorstep banking’ services to their customers, with the approval of their boards, thereby dispensing with the need for approval from the Reserve Bank. Under the scheme, banks can offer doorstep services such as pick up of cash/instruments, delivery of cash against

Box V.4
Evolving Framework for Financial Conglomerate Supervision in India

The Financial Conglomerate (FC) monitoring framework is operated on the following two tracks: (a) off-site monitoring of intra-group transactions and group-wide risks through a system of quarterly FC returns and (b) half-yearly discussions between the group representing all regulators concerned and the CEOs of the entities in the Group on significant issues relating to group-wide oversight structure, risk management, intra-group transactions etc. The half-yearly discussions enhance the understanding amongst the regulators about the affairs of the Groups. The responsibility of collecting FC data/information and forwarding the same on a quarterly basis to the principal regulator has been entrusted to the dominant/major entity in the Group (quite often the parent) which is called a “designated entity” (DE).

In view of the experience gained in monitoring of FCs over the past two years, new initiatives have been taken in consultation with the other regulators for further strengthening of the FC oversight framework. First, the FC identification criteria have been altered to bring under the oversight framework only such Groups which have significant presence in at least two of the five accepted financial market segments in India. It was decided not to treat the Primary Dealer business as a separate segment. Second, the FC returns have been amended in order to capture intra-group transactions and exposures of all the entities (including trusts/ SPVs) and also to appropriately focus on the supervisory issues. Third, the need for the principal regulator to engage in direct dialogue with the principal auditors of the Group has been agreed to help the regulators communicate supervisory concerns to the conglomerates more effectively. The modalities for the dialogue are being worked out. Finally, the principal regulators have also agreed in principle to undertake a joint study of the books of accounts and other operations of major entities in an identified financial conglomerate. The joint study is expected to not only back-test the efficacy of the reporting format in capturing the intra-group transactions/exposures and other ‘material’ information but also enhance the regulatory understanding of the affairs of the conglomerates.

Customer Service

V.38 The broad approach of the Reserve Bank to customer service is to empower the common person in availing banking services and strengthen customer-service delivery in banks by adopting a consultative process with banks through the Indian Banks’ Association (IBA).  Specifically, the focus is on (a) sensitising banks to customer service and encouraging the involvement of boards of banks, especially in matters relating to banks’ own grievance redressal machinery; (b) insisting on transparency in all dealings with the customers and ensuring reasonableness in pricing; (c) promoting adherence to self-imposed codes by banks on commitments to bank customers and monitoring compliance by an independent agency, viz., Banking Codes and Standards Board of India (BCSBI); (d) strengthening and empowering institutional mechanism for dispute resolution; (e) using regulation/prescription only when essential, while encouraging IBA to take initiatives; and (f) rationalising the Reserve Bank’s own systems and procedures.

V.39 With the setting up of the Customer Service Department on July 1, 2006 in the Reserve Bank, various customer service activities relating to the banks and the Reserve Bank, which were handled by different departments of the Reserve Bank, have been brought under a single roof (Box V.5).

V.40 The revised Banking Ombudsman Scheme, 2006 came into effect from January 1, 2006 and included many important features such as new grounds for complaints, easier complaint submission facility and appeal option to the complainants. During 2006-07, the functioning of the Banking Ombudsman offices was facilitated by fully operationalising the complaint tracking software, enabling complainants to file their complaints online. Under the revised Scheme, the Banking Ombudsman dealt with 26,062 complaints during July-December 2006. Of these, 18,117 complaints were disposed of, while 7,945 complaints were pending as on December 31, 2006. On May 24, 2007, the Scheme was amended to enable bank customers to appeal to the Reserve Bank against not only awards passed by the Banking Ombudsmen but also other decisions given by it in respect of complaints falling on such grounds specified in the Scheme.

Box V.5
Customer Service Department

The Reserve Bank has been vigorously pursuing the efforts to improve the customer service in the banking sector. Accordingly, it has been taking measures for protection of customers’ rights, enhancing the quality of customer service and strengthening the grievance redressal mechanism in banks and within the Reserve Bank itself. The activities pertaining to customer service in banks and the Reserve Bank were, however, being undertaken by its different departments. In order to reinforce its initiatives in the provision of customer services, it was decided to bring together all activities relating to customer service in banks and the Reserve Bank in a single department. The Reserve Bank, therefore, constituted a new department called the Customer Service Department (CSD), effective from July 1, 2006. The constitution of a new department focusing exclusively on customer services outlines the importance placed by the Reserve Bank on the delivery of customer services. The functions of the Customer Service Department include:

•   Dissemination of instructions/information relating to customer service and grievance redressal by banks and the Reserve Bank.

•   Overseeing the grievance redressal mechanism in respect of services rendered by the various Reserve Bank offices/departments.

•   Administration of the Banking Ombudsman (BO) scheme.

•   Acting as a nodal department for the Banking Codes and Standards Board of India (BCSBI).

•   Ensuring redressal of complaints on customer service in banks received directly by the Reserve Bank.

•   Liaison between banks, the Indian Banks’ Association, the BCSBI, the BO offices and the regulatory departments in the Reserve Bank on matters relating to customer services and grievance redressal.

The periodical feedback that the Department receives from the complaints dealt at the Banking Ombudsman offices has become one of the most important inputs for policy initiatives in the Reserve Bank.

V.41 All scheduled commercial banks/NBFCs involved in credit card operations were advised in November 2005 to maintain a ‘Do Not Call Registry’ in order to tackle the complaints relating to unsolicited commercial communications being received by customers/non-customers as part of the telemarketing efforts of banks and with a view to protecting the right to privacy of the members of the public. Despite this measure, complaints continued to be received from credit card subscribers.  To address this issue, the Telecom Regulatory Authority of India (TRAI) has framed the Telecom Unsolicited Commercial Communications (UCC) Regulations, 2007. The Regulations envisage setting up a mechanism by all telecom service providers to receive requests from subscribers who do not want to receive UCC and maintain and operate a private ‘do not call’ list. The telephone numbers and area code from this list will be updated online by the operators to a National Do Not Call Registry (NDNC) to be maintained by National Informatics Centre. Telemarketers will have to register in the NDNC Registry and would interact with it for updating their list. The guidelines issued by TRAI on June 6, 2007 mandate telemarketers to register themselves with Depar tment of Telecommunications (DoT) or any other agency authorised by DoT. In view of the above, banks have been advised not to engage telemarketers (DSAs/ DMAs) not having such valid registration certificate. The IBA shall coordinate with banks to furnish the list of telemarketers (DSAs/DMAs) engaged by them, along with the registered telephone numbers being used by them, to TRAI.

V.42 A ‘Code of Banks’ Commitment to Customers’ was released on July 1, 2006. The Code signifies the first formal collaborative effort by the Reserve Bank, the banks and the Banking Codes and Standards Board of India (BCSBI) to provide a framework for a minimum standard for banking services which individual customers can legitimately expect with reliability, transparency and accountability. The Code outlines how each bank expects to deal with the day-to-day requirements of the customers and accordingly, what each customer should reasonably expect from his/her bank. As at end-July 2007, 69 out of 84 SCBs had registered with the BCSBI.

V.43 In order to facilitate complaint submission by the customers, banks have been advised that a complaint form, along with the name of the nodal officer for complaint redressal, may be provided on their websites. The complaint form should also indicate that the first point for redressal of complaints is the bank itself and that complainants may approach the Banking Ombudsman only if the complaint is not resolved at the bank level within a month. Similar information is to be displayed in the boards put up in all the bank branches to indicate the name and address of the Banking Ombudsman. In addition, the name, address and telephone numbers of the controlling authority of the bank to whom complaints can be addressed are also to be given prominently.

V.44 In order to enhance the effectiveness of the grievance redressal mechanism, banks were advised in February 2007 to place a statement of complaints before their boards/customer service committees along with an analysis of the complaints received. Banks were also advised to disclose brief details of complaints dealt and the Banking Ombudsman awards issued against them along with their financial results. Furthermore, banks were advised to place a detailed statement/analysis of complaints on their websites for information of the general public at the end of each financial year.

V.45 In order to protect the rightful interest of borrowers and guard against undue harassment by lenders, the Reserve Bank had issued the guidelines on Fair Practices Code for Lenders in May 2003. Accordingly, banks/FIs were required to ensure that loan application forms in respect of priority sector advances up to Rs.2 lakh contain comprehensive information about the fees/charges and any other matter which affects the interest of the borrower. Banks/FIs were also required to convey in writing the reasons for rejection of loan applications of small borrowers seeking loans up to Rs.2 lakh. In March 2007, these guidelines were made applicable in respect of all categories of loans irrespective of the amount of loan sought. The provisions relating to rejection of applications were also applicable with respect to credit card applications.

V.46 Keeping in view the advantages of a handy and compact pass book as a ready reckoner for transactions and the problems associated with statement of accounts, banks (including UCBs) were advised (October 2006) to invariably offer pass book facility to all their savings bank account holders (individuals). In case, a bank offers the facility of sending statement of account and the customer chooses to get such a statement, the same must be provided to the customer on a monthly basis. Furthermore, the cost of providing such pass book or statements should not be charged to the customer. Banks were also advised (September 2006) to ensure that the full address and telephone numbers of branches are mentioned in the passbook/statement of accounts issued to the account holders in order to improve the quality of customer service in branches. It was also reiterated (December 2006) that banks should ensure the provision of both the drop box facility and the facility for acknowledgement of the cheques at the regular collection counters to customers1. In order to improve transparency, banks (including urban cooperative banks) were advised in July 2006 to place their service charges and fees on their websites at a prominent place under the title of ‘Service Charges and Fees’. A link to the websites of the banks has also been provided on the Reserve Bank’s website.

V.47 In 1999, the practice of fixing the benchmark service charges by the Indian Banks’ Association (IBA) on behalf of the member banks was discontinued and the decision to prescribe the service charges was left to the discretion of the boards of individual banks. Banks were then advised that they should ensure that the charges were reasonable and not out of line with the average cost of providing the services and that customers with low volume of activities were not penalised. However, the Reserve Bank continued to receive representations from the public regarding unreasonable and non-transparent service charges. Accordingly, in order to ensure fair practices in banking services, the Reserve Bank constituted a Working Group to formulate a scheme for ensuring reasonableness of bank charges. The Group submitted its report in August 2006 and banks have been advised to implement the accepted recommendations of the Working Group (Box V.6).

V.48 In view of several complaints being received by the Reserve Bank and Banking Ombudsman offices regarding levying of excessive interest and charges on certain loans and advances, boards of banks were advised in May 2007 to lay down appropriate internal principles and procedures within three months, so that usurious interest, including processing and other charges, are not levied by them on loans and advances, particularly, personal loans and such other loans of similar nature. Similar advices were issued to cooperative banks and NBFCs.

Box V.6
Reasonable Service Charges by Banks to Customers

The Working Group to formulate a scheme for ensuring reasonableness of bank charges examined various issues such as basic banking/financial services to be rendered to individual customers, the methodology adopted by banks for fixing and notifying the charges and the reasonableness of such charges.

The Working Group identified 27 services related to deposit/ loan accounts, remittance facilities and cheque collections, as an indicative list of basic banking services to be offered by banks. In order to ensure reasonableness in fixing and communicating the service charges, the Working Group suggested a set of principles. According to these, for basic services rendered to individuals, the banks should (a) levy charges at rates lower than the rates applied when the same services are given to non-individual entities; (b) levy charges only if they are just and supported by reason; and (c) levy service charges ad valorem only to cover incremental cost, subject to a cap. For basic services rendered to special category of individuals, banks should levy charges on more liberal terms than the terms on which the charges are levied to other individuals.

The recommendations of the Working Group were accepted by the Reserve Bank with certain modifications and the Reserve Bank advised banks in February 2007 to identify the basic banking services on the basis of the broad parameters indicated by the Working Group and implement the accepted recommendations of the Working Group on making available such services at reasonable prices/ charges. The list of services identified by the Working Group is only an indicative one and banks may, at their discretion, include within the category of basic services such additional services as they may consider appropriate. Banks are required to provide to customers complete information upfront on all charges applicable to basic services and any proposed changes in charges, in a timely manner. Changes in the service charges are to be carried out only with prior notice to the customers of at least 30 days. Banks should inform the customers in an appropriate manner regarding recovery of service charges. Banks are also required to inform customers in all cases where a transaction initiated by the bank itself results in or is likely to lead to a shortfall in the minimum balance required to be maintained. The recommendations of the Working Group relating to redressal of grievances and financial education may also be implemented by banks.

Regional Rural Banks

V.49 The process of amalgamation of regional rural banks (RRBs) initiated in September 2005 in order to strengthen them continued during 2006-07. With the amalgamation of 145 RRBs into 45 new RRBs, the total number of RRBs declined from 196 at end-March 2005 to 133 at end-March 2006 and further to 96 at end-March 2007.

V.50 Considering the critical role of the sponsor banks in positioning the RRBs as partners in the development of the rural sector and in order to encourage synergies between the parent bank and the RRBs, the Reserve Bank advised all sponsor banks to take steps on issues pertaining to human resources, information technology and operations of the RRBs sponsored by them.

V.51 With a view to improving the performance of the RRBs and giving more powers and flexibility to the boards of directors in decision making, the Reserve Bank constituted a Task Force (Chairman: Dr. K.G. Karmakar) (September 2006) to suggest areas where more autonomy could be given to the boards of the RRBs, par ticularly in matters of investments, business development and staffing. The Task Force, which submitted its Report in January 2007, recommended, inter alia, an increase in number of directors on the boards of the RRBs for large-sized banks, selection of Chairman on merit from a panel of qualifying officers, fixing a minimum period for tenure of Chairman, and extension of capital adequacy norms to RRBs. The recommendations of the Task Force are under implementation/examination.

V.52 The Union Budget for 2007-08 had, inter alia, announced that RRBs with a negative net worth would be recapitalised in a phased manner. Modalities for recapitalisation are being worked out by the Government of India in consultation with the State Governments and sponsor banks.

Deposit Insurance

V.53 A basic function of all deposit insurance systems is to reimburse depositors promptly for the losses in the event of an insured financial institution’s closure.  As per the Deposit Insurance and Credit Guarantee Corporation (DICGC) Act, 1961, the depositors’ dues are expected to be settled within a maximum period of five months from the date of assuming charge by the liquidator  or coming into force of the scheme. However, the time lag between the issue of liquidation order and actual reimbursement to the depositor was observed to be very large due to various factors, viz., non-receipt of claim lists, delay in appointment of liquidators and court cases. Therefore, the DICGC framed a policy on expeditious settlement of claims of the depositors of insured banks. During the pendency of the Court case, where no injunction restraining the Corporation to settle the claim is passed, the claim will be settled against irrevocable undertaking given by the liquidator of the bank, binding the said bank to repay the whole amount released by the Corporation in case the liquidation order is set aside. Furthermore, where the claims are not received even after expiry of more than three months from the date of liquidator assuming charge of office, the Corporation will issue a public advertisement in local newspapers stating that, although the Corporation is ready to settle depositors’ claims, it is not able to do so due to non-submission of claim list by the liquidators. The depositors will be asked to contact the concerned banks/liquidators to furnish details of claims where required.  Before such a notice is issued, the concerned Registrar of Cooperative Societies will be given one month’s time to take up the matter with the concerned liquidators and arrange for quick submission of the claim list.

V.54 In terms of the proviso to Section 16 (1) of the DICGC Act, 1961, the total amount payable to any depositor in the same capacity and same right is not to exceed Rs.1 lakh.  Hitherto, the practice had been to interpret the accounts held in the name of two depositors jointly in the nomenclature of say A and B, and B and A, as if they were in the same capacity and same right. Therefore, balances in both the accounts were aggregated for arriving at the amount of claim payable. This procedure was followed for all types of accounts viz., savings, recurring, current and fixed deposits held in the names of same set of persons maintained in all branches of the bank. This policy led to several grievances from the depositors. In order to redress these grievances, the matter relating to interpretation of the expression “in the same capacity and same right” was examined afresh and the policy in this regard was modified. Hereafter, accounts held exactly in the same nomenclature and having names in the same order with different branches of the bank will be treated in the same capacity and same right. Thus, deposits held in the names of say A and B, and B and A, will be treated as two separate accounts and each joint account will be eligible for claim up to Rs.1 lakh. Similarly, in the case of three joint account holders, deposits held in the names of X, Y and Z should be considered in different capacity and right as compared to deposits held in Y, Z and X and Z, X and Y. With the adoption of this interpretation, a majority of the grievances of the depositors will be redressed.

Cooperative Banks

V.55 Urban cooperative banks (UCBs) play a significant role in achieving the objective of financial inclusion by providing credit and deposit facilities to middle/lower middle income people in urban/semi-urban areas. The Reserve Bank, therefore, continued with its policy initiatives during 2006-07 to ensure that these banks emerge as a sound and healthy network of jointly owned, democratically controlled, and ethically managed banking institutions, for providing need based quality banking services, essentially to the middle and lower middle classes and marginalised sections of the society.

V.56 The approach followed for strengthening the UCBs sector focuses on the following elements: (a) withholding, in each State, new licenses/new branch authorisations till the Reserve Bank has regulatory comfort; (b) consultative and collaborative handling of the problems at a decentralised level (State) with representation from all stakeholders to avoid problem of dual control; (c) professionalisation of audit and management through consent; (d) emphasis on minimising systemic impact on account of exit of weak banks; (e) encouraging mergers to facilitate non-disruptive exit; (f) incentivising the State governments to enter into MoUs by linking liberalisation/flexibility in operations of UCBs in the State with the signing of MoU; and (g) calibrating expansion incumbent on financial strength and regulatory comfort.

V.57 Given the present legal framework, the States which have a large number of UCBs were approached by the Reserve Bank for signing MoU in order to develop a coordinated approach for regulation and supervision of UCBs and address the problems of dual control. In the States that have signed the MoU, the Reserve Bank has constituted State-level Task Force for Cooperative Urban Banks (TAFCUBs) comprising representatives of the Reserve Bank, State Government and the UCBs. The TAFCUBs identify potentially viable and non-viable UCBs and suggest time-bound revival path for the former and non-disruptive exit route for the latter set of banks. The exit of non-viable banks could be through merger/ amalgamation with stronger banks, conversion into societies or ultimately, as a last resort, through liquidation. So far, MoUs have been signed with 12 State Governments, viz., Gujarat, Andhra Pradesh, Karnataka, Madhya Pradesh, Uttarakhand, Rajasthan, Chattisgarh, Goa, Maharastra, Haryana, National Capital Territory of Delhi and West Bengal; State-level TAFCUBs have also been constituted in these 12 States, which together account for 80 per cent of the total number of UCBs and 66 per cent of the total deposits of the sector. The MoUs have also been signed between the Reserve Bank and the Central Government in respect of Multi-State UCBs that account for another 25 per cent of deposits of the sector. As such, 83 per cent of the UCBs accounting for about 90 per cent of the total deposits are covered under the MoU arrangements. The problems of all such banks are being addressed through consultation with other significant stakeholders, viz., State/Central Government and Federation/Association of UCBs. With the comfort of coordinated supervision, UCBs in States which have signed the MoUs, have been enabled to expand their business by allowing them to open currency chests, sell units of mutual fund and insurance products, provide foreign exchange services, open new ATMs and convert extension counters into branches. Furthermore, banks in such states could also be considered for grant of license to open new branches.

V.58 The consolidation of the UCBs through the process of merger of weak entities with stronger ones has been set in motion by providing transparent and objective guidelines, taking into consideration the interests of depositors and financial stability. Pursuant to the issue of guidelines on mergers of the UCBs in February 2005 which delineate the pre-requisites and steps to be taken in this regard, the Reserve Bank received 71 proposals for merger in respect of 62 banks. The Reserve Bank has issued no objection certificates in 41 cases. Of these, 31 mergers have become effective upon the issue of statutory orders by the Central Registrar of Cooperative Societies (CRCS)/RCS concerned. Sixteen proposals for merger were rejected by the Reserve Bank, while three proposals were withdrawn by the banks. The remaining 11 are under consideration.

V.59 In the absence of other options for exit, 44 banks considered unviable were taken for liquidation during July 2005 to June 2007 upon cancellation/ refusal of their banking licence.  As the action was an outcome of the consultative process, the liquidation did not have any systemic implications.  The safety net provided through DICGC ensured that the small depositors’ interests were protected.

V.60 Given the heterogeneity of the UCB sector, a two track regulatory approach is being followed for UCBs. Accordingly, UCBs are classified under two categories, viz., (a) Tier I banks comprising unit banks having a single branch/Head Office with deposits up to Rs.100 crore and UCBs having multiple branches within a single district with deposits up to Rs.100 crore; and (b) Tier II banks comprising all the other banks. Relaxed prudential norms are applicable for Tier I banks.

V.61 As part of rationalisation of supervision, a simplified off-site surveillance (OSS) reporting system, comprising a set of five returns, has been introduced for Tier I banks having deposits of over Rs.50 crore. The larger UCBs are placed under a composite OSS reporting system of eight returns. A software has also been developed to facilitate electronic preparation and submission of all supervisory and regulatory (including OSS) returns to the Reserve Bank.

V.62 The share capital of UCBs does not have all the characteristics of equity, since the share capital can be withdrawn by members after the minimum lock-in period and can also be adjusted against their loans and advances. In order to explore various options for raising capital, a Working Group was constituted comprising representatives of the Reserve Bank, State Governments and the UCB sector to identify alternative instruments/avenues for augmenting the capital funds of UCBs. The Group submitted its Report in November 2006 (Box V.7).

V.63 To enhance professionalism and improve the quality of governance in UCBs, the Reserve Bank provides training for skill upgradation in all important areas of banking operations. Training programmes are conducted at regional centres, free of cost for all UCBs and are imparted in local/regional languages to enable local staff to attend the programme and absorb it without any difficulty. So far, 515 CEOs, 675 directors and 585 officials of UCBs, besides 97 liquidators and 163 auditors/chartered accountants have been trained as part of training programmes for UCBs in States that have signed MoU.

V.64 Well managed UCBs are being permitted to set up select offsite/onsite ATMs, based on the recommendations of the concerned TAFCUB, subject to the following eligibility norms: (i) minimum deposits of Rs.100 crore; (ii) compliance with the prescribed CRAR; (iii) net NPA less than 10 per cent; and (iv) consistent record of profitability and compliance with the CRR/SLR stipulations. Scheduled UCBs classified as Grade I do not require prior approval of the Reserve Bank for setting up onsite ATMs. Offsite ATMs approved by the Reserve Bank have to be installed within the area of operation of the UCBs and shifting or relocation requires prior approval. UCBs permitted to have ATMs may also issue ATM-cum-Debit Cards. Prior approval of the Reserve Bank for network connectivity and/or sharing of the ATMs has been dispensed with.

Box V.7
Report of the Working Group on Issues Concerning Raising of Capital by UCBs

The Group recommended that the State Governments may exempt the UCBs from the existing monetary ceiling on individual shareholding to enable the UCBs with low capital or negative net worth to shore up their capital base.

The Group identified the following four new instruments to enable the UCBs to raise long term capital/quasi-capital funds: • unsecured, subordinated (to the claims of depositors), non-convertible, redeemable debentures/bonds • special shares (to be non-voting, perpetual and transferable by endorsement and delivery) • redeemable cumulative preference shares • long-term subordinated deposits with maturity in excess of 15 years which would be ineligible for the DICGC cover.

With regard to these instruments, the Group recommended that while the funds raised through the special shares - non-voting in nature which could be issued even at a premium -may be reckoned for Tier I capital, those raised through the other three instruments may be treated as Tier II capital. None of these instruments would have a put option but could have a call option exercisable by the bank with the prior permission of the Reserve Bank. Exercise of call option/redemption in the case of debentures/bonds and special shares would be subject to a lock-in clause of the bank meeting the prescribed CRAR at the relevant time. The Group suggested necessary amendments to the Acts/ Rules to facilitate issuance of some of the instruments proposed by it. The Group also recommended that the Reserve Bank may: • exempt commercial banks from the rating requirement to enable them to invest in special shares and Tier II bonds issued by the UCBs within the ceiling prescribed for investment in unlisted securities.

• permit the UCBs to invest in Tier II bonds of other UCBs, subject to appropriate limits linked to the investing/ recipient bank’s net owned funds.

• treat Tier II capital raised by banks with negative net worth as part of regulatory capital even if Tier I capital is negative. • dispense with extant instructions on share to loan ratios, since the UCBs have been subjected to the capital adequacy norms.

V.65 To enable the UCBs to provide better customer service, they were allowed to undertake the following limited transactions at the extension counters: (i) deposit/withdrawal; (ii) issue and encashment of drafts, mail transfers and travellers’ cheques; (iii) collection of bills; (iv) advances against fixed deposits of their customers (within the sanctioning power of the concerned official at the extension counter); and (vi) disbursement of other loans (only for individuals) sanctioned by the Head Office/base branch up to the limit of Rs.10 lakh.

V.66 UCBs were advise to ensure that they are fully compliant with the Anti-Money Laundering (AML) standards. The chief executive officers (CEOs) of UCBs are required to personally monitor the progress in implementing the KYC guidelines and the AML procedures in letter and spirit and put in place a system of fixing responsibility for breach of instructions issued. They are also required to furnish a compliance certificate in this regard.

V.67 Guidelines were issued to all Multi-State Primary UCBs for settlement of chronic NPAs, especially in the small and medium enterprises (SME) sector, under one time settlement (OTS) scheme. For this purpose, the small scale industrial units are defined as undertakings in which investment in plant and machinery does not exceed Rs.1 crore, except in respect of units manufacturing hosiery, hand tools, drugs and pharmaceuticals, stationery items and sports goods where the investment limit is Rs.5 crore. Units with investment in plant and machinery in excess of the SSI limit and up to Rs.10 crore are treated as medium enterprises (MEs). These guidelines do not cover loans availed of/guaranteed by directors/their relatives/firms or companies in which directors are interested and cases of wilful defaults, frauds and malfeasance.

V.68 On the basis of the recommendations of the Task Force on Revival of Rural Cooperative Credit Institutions (Chairman: Prof. A. Vaidyanathan), the Government of India has prepared a package for revival of the short-term rural co-operative credit structure. A National Implementing and Monitoring Committee (NIMC) has been set up to oversee implementation and monitoring of the revival package. So far, twelve States, viz., Maharashtra, Madhya Pradesh, Orissa, Rajasthan, Andhra Pradesh, Haryana, Gujarat, Uttarakhand, Uttar Pradesh, Bihar, West Bengal and Arunachal Pradesh have entered into Memorandum of Understanding with the Government of India and NABARD.

V.69 In January 2005, the same Task Force was also assigned the work of recommending measures for strengthening the long-term co-operative credit structure (LTCCS) for agriculture and rural development. The Task Force submitted its final report to the Government of India in August 2006 which has been forwarded to the State Governments for their comments.

V.70 As at end-March 2007, 127 out of 367 district central co-operative banks (DCCBs) and seven out of 31 State co-operative banks (StCBs) did not comply with the provisions of Section 11 (1) of the Banking Regulation Act, 1949 (As Applicable to Cooperative Societies). Similarly, 127 DCCBs and 7 StCBs did not comply with the provisions of Section 22(3)(a) of the Act and 333 DCCBs did not comply with Section 22(3)(b) of the Act as at end-March 2007. Two DCCBs were granted banking licence during 2006-2007.  Thus, the total number of licensed StCBs and DCCBs stood at 14 and 75, respectively, as at end-March 2007. At present, two StCBs and nine DCCBs have been placed under directions issued under Section 35A of the Banking Regulation Act, 1949, prohibiting them from accepting fresh deposits, allowing withdrawal of deposits in excess of stipulated amount, granting loans and advances.

Financial Institutions

V.71 Norms for income recognition, asset classification, provisioning and other related matters concerning Government guaranteed exposures for financial institutions were modified during 2006-07. Until then, asset classification and provisioning requirement in respect of State Government guaranteed exposures were contingent upon the invocation of State Government guarantee. Pursuant to the recommendations of the Technical Group on Refinancing Institutions (Chairman: Shri G.P. Muniappan), the asset classification and provisioning requirement were de-linked from the invocation of guarantee. Effective March 31, 2007, State Government guaranteed advances and investments in State Government guaranteed securities would attract the asset classification and provisioning norms if the interest and/or principal or any other amount due to the FI remained overdue for more than 90 days. However, the period of default in respect of agricultural activity would be related to the agricultural cycle instead of 90 days. The credit facilities backed by guarantee of the Central Government, though overdue, may be treated as NPA only when the Government repudiates its guarantee when invoked. This provision is, however, not applicable in the case of income recognition, where the existing norms continue.

Non-Banking Financial Companies

V.72 Non-banking financial companies (NBFCs) play a crucial role in broadening the access to financial services, enhancing competition and diversifying the financial sector. Some NBFCs have been given the status of a conglomerate, in view of the wide nature of activities undertaken by them, which fall under the jurisdiction of more than one financial sector regulator. Accordingly, the need to strengthen these entities while simultaneously monitoring their activities to mitigate the systemic risks has assumed significance. The Reserve Bank has, therefore, been strengthening the regulatory and supervisory framework for NBFCs since 1997 with the aim of making the NBFC sector vibrant and healthy. These efforts were pursued further during 2006-07.

V.73 NBFCs are increasingly being recognised as complementary to the banking system; they are capable of absorbing shocks as also spreading risks at times of financial distress. The application of different levels of regulations to the activities of banks and NBFCs, and even among different categories of NBFCs, had given rise to some issues arising out of the uneven coverage of regulations. Based on the recommendations of an Internal Group to examine the issues relating to the level playing field, regulatory convergence and regulatory arbitrage in the financial sector and taking into consideration the feedback received thereon, it was decided to put in place a revised framework to address the issues pertaining to the overall regulation of systemically important NBFCs and the relationship between banks and NBFCs (Box V.8). Furthermore, under the revised framework, non-deposit taking NBFCs with asset size of Rs 100 crore and above have been defined as ‘systemically important NBFCs’ (NBFC-ND-SI). Such NBFCs are required to maintain a minimum CRAR of 10 per cent and should not (i) lend to any single borrower/any single group of borrowers more than 15 per cent/25 per cent of their owned funds, respectively; (ii) invest in the shares of another company/any single group of companies more than 15 per cent/25 per cent of their owned funds, respectively; and (iii) lend and invest (loan/investment taken together) more than 25 per cent/40 per cent of their owned funds to a single party/a single group of parties, respectively. The above credit/investment norms can be exceeded by 5 percentage points for any single party and by 10 percentage points for a single group of parties, if the additional exposure is on account of infrastructure loan and/or investment. Asset finance companies (AFCs) are permitted to exceed the exposure norms up to a fur ther 5 percentage points of their owned funds, in exceptional circumstances with the approval of their boards. NBFC-ND-SI not accessing public funds, both directly and indirectly, may apply to the Reserve Bank for an appropriate dispensation, consistent with the spirit of the exposure limits. The ceiling on investment is not applicable to investment by NBFCs in the equity capital of an insurance company to the extent permitted by the Reser ve Bank. The revised framework was made effective from April 1, 2007. The residuary non-banking companies (RNBCs) and primary dealers will continue to be governed by the extant guidelines, pending a review.

Box V.8
Banks and Financial Regulation of Systemically Important NBFCs

In view of the regulatory gaps in the area of bank and NBFC operations, the existing framework of prudential regulations for bank and NBFC operations was reviewed based on the following principles: (i) All systemically relevant entities offering financial services ought to be brought under a suitable regulatory framework to contain systemic risks; (ii) focus should be on activity-centric regulation rather than institution-centric regulation in order to reduce or eliminate scope for regulatory arbitrage; (iii) the ownership pattern of NBFCs should be such that more than one entity in the Group does not compete for public deposits; (iv) the ownership structure of NBFCs should not be the determining factor to decide on the products that NBFCs may offer; (v) foreign entities which can undertake certain permitted activities in India under the automatic route for FDI should not later expand into activities which are not permitted under the automatic route without going through a further authorisation process; and, (vi) banks should not use an NBFC as a delivery vehicle for seeking regulatory arbitrage opportunities or to circumvent bank regulation(s) and that activities of NBFCs do not undermine banking regulations.

Keeping in view the above principles, the following broad modifications were made in the regulatory framework for banks:

(i) The exposure (both lending and investment, including off- balance sheet exposures) of a bank to a single NBFC/ NBFC-Asset Finance Companies (AFC) should not exceed 10 per cent/15 per cent of the bank’s capital funds as per its last audited balance sheet. The exposure ceilings would be 15 per cent/20 per cent of the capital funds, in case the exposure in excess of 10 per cent/15 per cent is on account of funds on-lent by the NBFC-AFC to infrastructure sectors.

(ii) NBFCs promoted by the parent/group of a foreign bank having presence in India, which is a subsidiary of the foreign bank’s parent/group or where the parent/group is having management control, would be brought under the ambit of consolidated supervision.
(iii) Bank sponsored NBFCs, currently not permitted to offer discretionary portfolio management services (PMS), will be allowed to offer discretionary PMS to their clients, on a case by case basis.

(iv) Banks in India, including foreign banks operating in India, shall not hold more than 10 per cent of the paid-up equity capital of a deposit taking NBFC, except in the case of housing finance companies.

Banks were required to comply with the modified regulations with effect from April 1, 2007.

V.74 In order to ensure improved customer satisfaction as also to impart transparency to their lending operations, NBFCs were advised in September 2006 to put in place the Fair Practices Code. The Code mandates a minimum benchmark, leaving the discretion to the NBFCs to enhance the practices. The guidelines in this respect require the NBFCs to, inter alia, provide the specified information in loan application forms; introduce a system of acknowledgement for receipt of all loan applications; indicate a timeframe for disposal of loan applications; convey in writing to the borrower the amount of loan sanctioned along with the terms and conditions including annualised rate of interest and method of application thereof; give notice to the borrower of any change in terms and conditions; refrain from interference in the affairs of the borrower; and refrain from undue harassment of the borrower in the matter of recovery of loans. The boards of directors of NBFCs should also put in place appropriate grievance redressal mechanism within the organisation to resolve disputes arising in this regard.

V.75 NBFCs no longer engaged in the business of non-banking financial institution (NBFI) were observed to be holding the certificate of registration (CoR) granted by the Reserve Bank, although they are not required/eligible to hold the same. NBFCs were, therefore, advised in September 2006 to submit a certificate from their Statutory Auditors every year to the effect that they continue to undertake the business of NBFI.

V.76 In terms of extant instructions, in the case of a change of management and control of NBFCs, prior public notice of 30 days was required before effecting the sale, or transfer of the ownership by sale of shares, or transfer of control, whether with or without sale of shares or by way of amalgamation/merger of an NBFC with another NBFC or a non-financial company by the NBFC and also by the transferor, or the transferee.

From October 2006, such prior public notice has to be given by the NBFC and also by the transferor or the transferee or jointly by the parties concerned.

V.77 In order to strengthen the NBFC sector by allowing diversification in their area of business, NBFCs were allowed in December 2006 to (i) market and distribute mutual fund products as agents of mutual funds; and (ii) issue co-branded credit cards with commercial banks, without risk sharing. These businesses, with the prior approval of the Reserve Bank for an initial period of two years (to be reviewed thereafter), would be subject to fulfilment of the following minimum requirements by the NBFCs: (a) minimum net owned fund of Rs.100 crore; (b) net profit as per last two years’ audited balance sheet; (c) net NPAs not exceeding 3 per cent of net advances, as per the last audited balance sheet; (d) CRAR of 10 per cent for non-deposit-taking NBFCs (NBFCs-ND) and 12 per cent/15 per cent for deposit-taking NBFCs (NBFCs-D). With regard to mutual fund business, NBFCs should, inter alia, also comply with SEBI guidelines/ regulations and they should only act as an agent and not acquire units of mutual funds. In the case of credit card business, the role of NBFC would, inter alia, be limited only to marketing and distribution.

V.78 The classification of NBFCs was modified in December 2006 to provide a separate classification for companies financing physical assets supporting productive/economic activity. Accordingly, NBFCs, whose principal business, i.e., not less than 60 per cent of their total assets and total income is from the financing of real/physical assets supporting economic activity such as automobiles, general purpose industrial machinery and the like, have been classified as asset finance companies (AFCs). Consequent upon this reclassification, the NBFCs earlier classified as equipment leasing (EL) companies and hire-purchase (HP) companies will emerge as asset finance companies. Since the classification for the purpose of income recognition, asset classification and provisioning norms is based on asset specification, the extant prudential norms continue as hitherto. However, the exposure norms relating to restriction on investments in land and buildings and unquoted shares would be modified and the provisions applicable to EL/ HP companies would also be applicable to AFCs.

V.79 Securitisation companies/reconstruction companies (SCs/RCs) were advised (September 2006) to invest in security receipts, issued by the trust set up for the purpose of securitisation, an amount not less than 5 per cent under each scheme.  In October 2006, the SCs/RCs, which had obtained a CoR from the Reserve Bank under Section 3 of the SARFAESI Act, 2002, were directed to commence business within six months from the date of grant of the CoR. The Reserve Bank may, on an application made by the SC/RC, grant extension of time for commencement of business beyond six months, up to a maximum of 12 months from the date of grant of the CoR. In May 2007, SCs/RCs registered with the Reserve Bank under the SARFAESI Act, 2002 were advised to declare net asset value of the security receipts issued by them at periodic intervals. The Reserve Bank has so far granted the CoR to six SCs/ RCs, of which three have commenced the business of securitisation/reconstruction of assets.

V.80 All NBFCs accepting/holding public deposits were hitherto required to create floating charge on the statutory liquid assets invested in favour of their depositors. In view of the practical difficulties in creating charge in favour of a large number of depositors, NBFCs accepting/holding public deposits were allowed (January 2007) to create the floating charge through the mechanism of ‘Trust Deed’, by March 31, 2007.

V.81 As the regulation of Mutual Benefit Financial Companies (Notified Nidhis) (MBFCs) and Mutual Benefit Companies (Potential Nidhis) (MBCs) has been taken over by the Ministry of Company Affairs (since renamed as the Ministry of Corporate Affairs), it was decided not to call for returns from MBFCs and MBCs. However, if the application of MBCs (Potential Nidhis) for the grant of the nidhi status is rejected by the Ministry, the provisions as applicable to NBFCs would apply to such companies.

V.82 In order to increase investor confidence through adoption of best corporate practices, deposit taking NBFCs with deposit size of Rs.20 crore and above and NBFCs-ND-SI have been advised to frame internal guidelines on corporate governance covering, inter alia, constitution of  audit committee, nomination committee and risk management committee, and disclosure and transparency practices.

MACRO-PRUDENTIAL INDICATORS REVIEW

V.83 The Reserve Bank has been compiling macro-prudential indicators (MPIs) since March 2000. These comprise both aggregated micro-prudential indicators (AMPIs) of the health of individual financial institutions and macroeconomic indicators (MEIs) associated with the financial system soundness. India is one of the countries which volunteered to participate in the coordinated compilation exercise of financial soundness indicators in December 2005 under the aegis of the International Monetary Fund.

V.84 An overview of MPIs for 2006-07 indicates a further improvement in asset quality of the major constituents of the financial sector (Table 5.4). Capital adequacy ratios continued to remain above the minimum requirements. Return on assets of scheduled commercial banks during 2006-07 remained almost unchanged at the previous year’s level, while that of primary dealers (PDs) witnessed a sharp decline due to the merger of nine stand-alone PDs into bank-PDs.

Capital Adequacy

V.85 The capital to risk-weighted asset ratio (CRAR) of scheduled commercial banks at end-March 2007 remained unchanged from the previous year, suggesting that the expansion of capital kept pace with the increase in total risk-weighted assets (Table 5.4). Growth in risk-weighted assets reflected (i) higher growth in the advances portfolio of banks as compared with investments in Government securities; (ii) increase in risk weights for personal loans, real estate and capital market exposure; and (iii) application of capital charge for market risk for investments held under the AFS category from March 2006. The core capital (i.e., Tier I) ratio of the banks declined from 9.3 per cent as at end-March 2006 to 8.3 per cent at end-March 2007. Only one old private sector bank, viz., Sangli Bank, could not comply with the prescribed minimum CRAR at end-March 2007 (Table 5.5). This bank was subsequently amalgamated with ICICI Bank.

V.86 The CRAR of the scheduled UCBs was 11.8 per cent at end-March 2007, lower than 12.7 per cent at end-March 2006 (Table 5.4). Out of 53 scheduled UCBs, the CRAR of 41 UCBs was over 9 per cent, while that of 10 UCBs was less than 3 per cent.
V.87 The aggregated CRAR of FIs increased from 22.3 per cent at end-March 2006 to 24.5 per cent at end-March 2007 (Tables 5.4 and 5.6). This was mainly on account of an increase in the aggregated CRAR of term-lending institutions facilitated by a turnaround in the net worth of IFCI.

V.88 The aggregated CRAR of the NBFCs increased from 14.8 per cent at end-March 2006 to 21.6 per cent at end-September 2006, well above the regulatory minimum [12 per cent for equipment leasing and hire purchase finance companies (categorised as asset finance companies from December 2006) and 15 per cent for other NBFCs]. However, seven large companies reported negative CRAR. As at end-September 2006, 84.9 per cent of the reporting companies had CRAR equal to or in excess of 12 per cent (Chart V.1). The CRAR of PDs continued to be at a high level even as it declined to 33.4 per cent at end-March 2007 from 53.9 per cent at end-March 2006 due to the merger of high CRAR entities with their parent/group banks.

Asset Quality

V.89 Asset quality of scheduled commercial banks improved further during the year, with gross and net NPA ratios declining to 2.7 per cent and 1.1 per cent, respectively, at end-March 2007 (Table 5.7). Robust economic activity and better recovery climate have facilitated the reduction in non-performing assets in recent years. Net NPAs of only two banks were in excess of 5 per cent of net advances (Table 5.8). Asset quality of financial institutions and scheduled UCBs also improved during 2006-07, with net NPAs at 0.1 per cent and 2.4 per cent, respectively, of their net

assets as at end-March 2007 (see Table 5.4). Out of 53 scheduled UCBs, net NPA of 18 UCBs were in excess of 5 per cent of their advances (Table 5.9).

Earnings and Profitability Indicators

V.90 Total income of SCBs increased marginally from 8.03 per cent of their assets in 2005-06 to 8.04 per cent in 2006-07 due to an increase in interest income resulting mainly from a significant rise in credit offtake (Table 5.10).

V.91 Higher interest expenses, however, led to a sharper increase in total expenditure (as per cent to total assets), despite the fall in operating expenses. As a result, during 2006-07, profits before provisions and taxes (as per cent to total assets) were lower than those in the previous year. However, profit after tax (as per cent to total assets) at 0.90 per cent during 2006-07 was marginally higher than that during 2005-06 (0.88 per cent) due to lower provisions. As many as 45 banks (out of 82 banks) recorded an increase in the profits ratio during the year (Table 5.11).

V.92 Total income of UCBs declined marginally from 6.42 per cent of their assets in 2005-06 to 6.40 per cent in 2006-07 due to decline in non-interest income. Earnings before provisions and taxes were, however, higher on account of increase in interest income and decline in interest expenses (as percentage to total assets). Provisions made in 2006-07 were higher than those in 2005-06.  The return on total assets of scheduled UCBs declined marginally to 0.69 per cent in 2006-07 from 0.71 per cent in 2005-06. (Table 5.12).

V.93 The return on assets of PDs declined to 2.92 per cent during 2006-07 from 5.04 per cent during 2005-06, reflecting the merger impact.

Sensitivity to Market Risk

Interest Rate Risk

V.94 The investment portfolio of the scheduled commercial banks has become relatively less sensitive to interest rate risk on account of shifting of major portion of investments to HTM category (60 per cent), which are not required to be marked to market unlike those in the trading book. Furthermore, given the relative unattractiveness of investments in government securities in an increasing interest rate scenario, banks restricted/liquidated their investments to fund credit growth which is expected to reduce the impact of the rising yields on the banks’ balance sheets. Banks have adopted various portfolio management techniques like reduction of duration, particularly in the case of trading book in conjunction with reduction in the size of the trading book itself, to immunise themselves from marked to market losses.