Chapter II

2.1 Financial intermediaries are going through significant changes all over the world under the impact of deregulation, technological upgradation and financial innovations. Indeed, the traditional face of banking is no longer as it was even a few years ago. The way financial services are provided are changing dramatically. In many countries, banks are now providing services that do not come under the domain of traditional banking. The old institutional demarcations are getting increasingly blurred. Consequently, increased competition from non-bank intermediaries has led to a decline in traditional banking wherein banks only accepted deposits and made advances that stayed on their books till maturity. The business of banking has been moving rapidly in recent years to a ‘one-stop shop’ of varied financial services. This process of transformation is particularly striking in emerging market economies like India.

2.2 Recent international financial developments have also brought into sharp focus the importance of regulation and supervision of the financial system. In India, financial sector reforms have sought to strengthen the regulatory and supervisory framework and to bring them at par with the international best practices with suitable country-specific adaptations. This has been the guiding principle in the approach to the New Basel Accord. During 2002-03, improvements in management of risk and non-performing assets (NPAs) were sought to be achieved through the issuance of comprehensive guidelines on credit, market, country and operational risks to banks, and through the implementation of several regulatory changes. The changes in supervision included progress towards risk-based and consolidated supervision. Steps were also taken to improve credit delivery and to strengthen the technological and legal infrastructure.

2.3 In the context of the changing contours of banking, the present Chapter provides an overview of the policy initiatives in the Indian commercial banking sector during 2002-03 as well as 2003-04, so far. The overall thrust of monetary and credit policy and changes in its instruments and variables in terms of interest rates, refinance facilities and statutory preemptions are presented first. This is followed by developments in supervision and supervisory policy. In the context of ensuring a stable and sound banking system, policy developments regarding risk management and management of non-performing assets are discussed next. This is followed by a brief delineation of the evolving consultative approach to policy formulation. A discussion on steps for improvement in credit delivery, changes in money and Government securities markets and technological and legal infrastructure are presented in the subsequent sections. Actions taken on recommendations of the Joint Parliamentary Committee (JPC) on Stock Market Scam and Matters Relating Thereto are presented at the end of the Chapter.

2. Monetary and Credit Policy

2.4 A vibrant, resilient and competitive financial sector is vital for a growing economy. The Reserve Bank’s endeavour has been to enhance the allocative efficiency of the financial sector and to preserve financial stability. Consequently, the Monetary and Credit Policy statements of the Reserve Bank have been focusing on the structural and regulatory measures to strengthen the financial system. The monetary policy framework has evolved over the recent period in response to the reforms in the financial sector. The reform measures have been guided by the objectives of increasing operational efficacy of monetary policy, redefining the regulatory role of the Reserve Bank, strengthening prudential norms, improving credit delivery systems, and developing technological and institutional infrastructure. In order to achieve the above objectives, the Reserve Bank has been adopting a policy of extensive consultations with experts and market participants before introducing policy measures while allowing sufficient lead time for better preparedness.

2.5 The monetary policy stance in recent years has underlined the Reserve Bank’s commitment to maintain adequate liquidity in the market with a preference for soft interest rates, in order to revive economic growth while keeping a vigil on the price level. The monetary and credit policy for 2002-03 was set against the backdrop of easy liquidity conditions fostered by strong capital flows and weak credit off-take. Under the circumstances, the Reserve Bank proposed to continue its policy of active demand management of liquidity in order to maintain the current interest rate environment with a bias towards a soft interest rate regime in the medium-term. The overall stance of monetary policy for 2002-03 consisted of:

• Provision of adequate liquidity to meet credit growth and support investment demand in the economy while continuing a vigil on movements in the price level;
• In line with the above, continuation of the present stance on interest rates including preference for soft interest rates; and
• Imparting greater flexibility to the interest rate structure in the medium-term.

2.6 The monetary and credit policy of 2003-04 has proposed to continue with the broad policy stance of the previous year.

Interest Rate Structure

Bank Rate and Repo Rate

2.7 The monetary policy stance of preference for a soft and flexible interest rate regime for generating growth impulses was supported by the Reserve Bank’s money market operations that combined judiciously open market operations and the Liquidity Adjustment Facility (LAF). The cut in the Bank Rate from 6.5 per cent to 6.25 per cent effective October 30, 2002 had a sobering impact on the structure of interest rates. The Bank Rate was further reduced by 25 basis points to 6.0 per cent on April 29, 2003. Moreover, in terms of short-term signalling, the one-day and 14 day repo rates were reduced from 6.0 per cent to 5.75 per cent effective June 27, 2002 and further to 5.5 per cent and 5.0 per cent effective October 30, 2002 and March 4, 2003, respectively. In view of the macroeconomic and overall monetary conditions, one-day repo rate was reduced further on August 25, 2003 to 4.5 per cent.

Interest Rates on Deposits

2.8 The interest rates on domestic and ordinary non-resident savings deposits as well as the Non-resident (External) Savings Accounts Scheme were reduced from 4.0 per cent to 3.5 per cent per annum effective March 1, 2003. The interest rate on deposits in Account ‘A’ under the Capital Gain Account Scheme, 1988 introduced by the Government of India, was also revised downwards from 4.0 per cent to 3.5 per cent per annum with effect from March 1, 2003.

NRI Deposit Scheme

2.9 As announced in the Monetary and Credit Policy for 2003-04, it was decided that, with a view to providing uniformity in the maturity structure for all types of repatriable deposits, the maturity period of fresh non-resident external (NRE) deposits will normally be one year to three years, with immediate effect. If a bank wishes to accept deposits with a maturity of more than three years, it may do so provided the interest rate on such long-term deposits is not higher than that applicable to three-year NRE deposits. In order to bring consistency in interest rates offered to non-resident Indians, the interest rates on NRE deposits for one to three years contracted effective July 17, 2003 were limited to not exceeding 250 basis points above the LIBOR / SWAP rates for US dollar of corresponding maturity. The ceiling rate was later reduced on September 15, 2003 to 100 basis points and further, on October 18, 2003, to 25 basis points above the corresponding US dollar LIBOR / SWAP rates.

Interest Rates on Advances

2.10 In supersession of the earlier instructions on the system of charging interest on loans and advances at monthly rests, the banks have been advised the following:

• banks have the option to compound interest at monthly rests effective either from April 1, 2002, or July 1, 2002 or April 1, 2003;
• with effect from quarter beginning July 1, 2002, banks should ensure that the effective rate does not go up merely on account of the switchover to the system of charging / compounding interest at monthly rests and increase the burden on the borrowers; interest at monthly rests shall be applied to all running accounts (e.g., cash credit, overdraft, export packing credit), all new and existing term loans and other loans of longer / fixed tenor but not to agricultural advances; and
• banks may obtain consent letters / supplemental agreements from the borrowers for the purpose of documentation.

Lending Rates (Non-Export Credit)

2.11 A soft and flexible interest rate regime has generally meant lower deposit rates. With the decline in the cost of funds to the banking sector, the Prime Lending Rates (PLRs) of commercial banks have also declined. The decline in PLRs, however, was somewhat muted given the structural rigidities, such as, high non-interest operating expenses and cost of servicing non-performing loans. Furthermore, banks have mobilised a large proportion of their deposits at relatively high fixed rates, which also limited the downward shift in the PLRs. In order to impel banks to reduce their lending rates, the Reserve Bank has encouraged them to improve manpower productivity and reduce establishment costs. Banks have also been advised on the need to reduce spreads over PLR. Nevertheless, as banks have been permitted to lend to exporters and their prime customers at sub-PLR rates effective April 19, 2001, the cost of bank borrowings to such corporates has been coming down even further.

2.12 In order to reduce information asymmetries, as proposed in the Monetary and Credit policy for 2002-03, the Reserve Bank is presently disseminating the bank-wise information on lending rate after consultation with select banks on its website.

2.13 In the annual policy Statement of April 2003, banks were advised to announce a benchmark PLR with the approval of their Boards, taking into consideration: (i) actual cost of funds, (ii) operating expenses and (iii) a minimum margin to cover regulatory requirements of provisioning and capital charge, and profit margin. It was also indicated that the system of determination of benchmark PLR by banks and the actual prevailing spreads around the benchmark PLR would be reviewed in September 2003. Accordingly, the issues relating to the implementation of the system of benchmark PLR were discussed with select banks and the Indian Banks Association (IBA). The IBA has made the following suggestions: (i) permitting separate PLRs for working capital and term loans, (ii) continuation of the practice of multiple PLRs, (iii) flexibility in offering fixed or floating rate loans based on time-varying term premia and market benchmarks, (iv) flexibility in pricing of consumer loans, and (v) accounting for transaction costs for different types of loans.

2.14 In the Mid-term Review of Monetary and Credit Policy for 2003-04, it was clarified that since lending rates for working capital and term loans can be determined with reference to the benchmark PLR by taking into account term premia and/or risk premia, a need for multiple PLRs may not be compelling. It is also clarified that banks have the freedom to price their loan products based on time-varying term premia and relevant transaction costs. Banks may price floating rate products by using market benchmarks in a transparent manner. As IBA has indicated broad agreement with the approach proposed for the benchmark PLR, IBA may advise its members suitably, keeping in view the operational requirements.

Interest Rate on Export Credit

2.15 The Monetary and Credit Policy for 2002-03 also indicated that linking domestic interest rates on export credit to PLR has become redundant under the present circumstances as effective interest rates on export credit in Rupee terms were substantially lower than the PLR. Therefore, in order to encourage competition among banks and also to increase flow of credit to the export sector, the Reserve Bank liberalised the interest rates on local currency export credit effective May 1, 2003 for pre-shipment credit above 180 days and post-shipment credit above 90 days.

Refinance

Export Credit Refinance facility

2.16 With effect from April 1, 2002, scheduled commercial banks (SCBs) are provided export credit refinance to the extent of 15.0 per cent of the outstanding export credit eligible for refinance as at the end of the second preceding fortnight.

2.17 After deregulation of interest rates on post-shipment rupee export credit beyond 90 days and up to 180 days with effect from May 1, 2003, it was decided, in response to suggestions received from the exporting community, that the refinance facility would continue to be extended to eligible export credit remaining outstanding under post-shipment rupee credit beyond 90 days and up to 180 days.

Collateralised Lending Facility - Withdrawal

2.18 The liquidity support under the Collateralised Lending Facility (CLF) was provided to SCBs against the collateral of excess holdings of Government of India dated securities/Treasury bills over their SLR requirement. The extent of liquidity support available to each bank under the CLF was stipulated at 0.25 per cent of its fortnightly average outstanding aggregate deposits in 1997-98. However, subsequent to reduction in refinance limits under CLF by 50 per cent in two stages of 25 per cent each effective July 29, 2000 and August 12, 2000 the limit was reduced to 0.125 per cent of aggregate deposits of each bank in 1997-98. With the emergence of Liquidity Adjustment Facility (LAF) as the primary instrument for modulating systemic liquidity on a day-to-day basis, limits under CLF were reduced by another 50 per cent effective July 27, 2002 before it was completely withdrawn from October 5, 2002.

Statutory Pre-emptions

Cash Reserve Ratio (CRR)

2.19 There has been a distinct shift in the monetary policy framework and operating procedures from direct instruments of monetary control to market-based indirect instruments in the recent years. The rationalisation of CRR and its maintenance facilitated reducing reliance on reserve requirements, even while retaining it as a monetary tool. The CRR of SCBs that was at 15.0 per cent of Net Demand and Time Liabilities (NDTL) between July 1, 1989 and October 8, 1992 was brought down in phases to 4.5 per cent on June 14, 2003. While the CRR reduction over the last few years has been consistent with the objective of reducing it to the statutory minimum level of 3.0 per cent, the Reserve Bank could continue to use the instrument, in either directions, for liquidity management, taking into account the liquidity conditions, inflation trends and other macroeconomic developments. For example, the reserve requirements were increased temporarily in 1997 to combat pressures arising from contagion from East Asian financial crisis. However, as part of the medium-term objective of reducing CRR to its statutory minimum and also to step up lendable resources of the banks to support real activity, the CRR was reduced by as much as 400 basis points over last three years, with a reduction of 25 basis points since June 2003.

Statutory Liquidity Ratio (SLR)

2.20 While there was no change in SLR requirements during 2002-03 for SCBs in general, policy changes were effected in respect of composition of SLR assets of RRBs in 2002-03 on prudential considerations. The RRBs’ balances maintained in call money or fixed deposits with their sponsor banks were earlier treated as ‘cash’ and hence reckoned towards their maintenance of SLR. As a prudential measure, RRBs were advised in April 2002 to maintain their entire SLR holdings in Government and other approved securities. Specifically, RRBs were advised to convert their existing deposits with sponsor banks into Government securities by March 31, 2003. A number of RRBs have already achieved the minimum level of SLR in Government securities. Some RRBs and their sponsor banks, however, expressed difficulties relating to premature withdrawal of deposits reckoned for SLR purposes and those were allowed to retain such deposits till maturity. RRBs were advised to achieve the target of maintaining 25 per cent SLR in Government securities and, on maturity, their deposits with sponsor banks may be converted into Government securities to be reckoned for SLR purposes.

Mid-Term Review of Monetary and Credit Policy for 2003-04

2.21 The Mid-term Review of Monetary and Credit Policy for 2003-04, announced on November 3, 2003 reviewed the recent monetary and macro developments in the Indian economy with expectations of higher GDP growth during 2003-04 (placed at 6.5 - 7.0 per cent, with an upward bias) and benign inflation outlook (4.0-4.5 per cent, with a downward bias). It was proposed to continue with the overall stance of monetary policy announced in April 2003 in terms of provision of adequate liquidity to meet credit growth and supporting investment demand with a vigil on the price level and a preference for soft and flexible interest rate environment. The Mid-term Review emphasised continuance of measures already taken with an accent on implementation, facilitating ease of transactions by the common persons, further broadening of the consultative process and continued emphasis on institutional capacity to support growth consistent with stability in a medium-term perspective (Box. II.1).

3. Supervision and Supervisory Policy¹ Supervision

Board for Financial Supervision

2.22 The Board for Financial Supervision (BFS), set up in November 1994 under the Reserve Bank of India (Board for Financial Supervision) Regulations, is entrusted with the supervision of commercial banks, select financial institutions (FIs) and non-banking financial companies (NBFCs). During the period from July 2002 to June 2003, the BFS reviewed the performance of banks, FIs and local area banks with reference to their position as on March 31, September 30 and December 31, 2002.

2.23 The BFS reviewed the monitoring by the Reserve Bank with regard to bank frauds and house-keeping in public sector banks (PSBs) including reconciliation of entries in inter-branch accounts, inter-bank accounts (including nostro accounts) and balancing of the books of accounts. Since it was perceived that a major reason behind bank frauds is non-observance of the laid down rules and procedures, based on the Report of the Expert Committee on Legal Aspects of Bank Frauds (Chairman: Dr. N.L. Mitra), all banks were advised to ensure that each and every desk in the branches certify that there was no laxity in implementing the laid down systems and procedures. Similarly, in the area of reconciliation of entries in inter-branch and inter-bank as well as balancing of books of account, considerable improvement has been ensured through constant monitoring by the Reserve Bank and continuous review by the BFS. The BFS also reviewed the monitoring of select all-India FIs and NBFCs over which the Reserve Bank has regulatory jurisdiction. Besides delineating the course of action to be pursued in respect of institution-specific supervisory concerns, the BFS provided guidance on several regulatory and supervisory policy issues. In addition, the BFS reviewed the status of supervision of urban co-operative banks. Considering the poor inherent financial strength of existing local area banks (LABs), the policy for licensing of LABs was revised.

2.24 A supervisory rating model for the FIs was approved and introduced from the inspection of 2002-03. The report on the weak / problem NBFCs with public deposits of Rs.20 crore and above is being reviewed by the BFS on a quarterly basis. However, with a view to protecting the interest of depositors in medium-sized companies as well, weak and problematic NBFCs, with public deposits of Rs.10 crore and above, have been brought within the purview of quarterly review of the BFS.

Annual Financial Inspections

2.25 For the year 2002-03, Annual Financial Inspections of 92 banks (26 PSBs, 30 private sector banks and 36 Foreign banks), 14 Local Head Offices of SBI and 4 LABs have been completed under Section 35 of Banking Regulation Act, 1949. Nine all-India FIs were inspected under Section 45 N of the Reserve Bank of India Act, 1934. Inspection of 4 foreign banks, closing their operations in India, was carried out under Section 44 of the Banking Regulation Act, 1949.

Box II.1: Major Policy Measures Announced in the Mid-term Review of Monetary and Credit Policy for the year 2003-04 1. Monetary Measures: Bank Rate was kept unchanged at 6.0 per cent, prevailing since April 29, 2003. Cash Reserve Ratio (CRR) was kept unaltered at 4.50 per cent, prevailing effective fortnight beginning June 14, 2003, in view of the existing liquidity situation. 2. Interest Rate Policy: It was clarified that since lending rates for working capital and term loans can be determined with reference to the benchmark PLR, by factoring in term premia and / or risk premia, a need for multiple PLRs may not be compelling. Banks were free to price their loan products based on time-varying term premia and relevant transaction costs. Freedom has also been given for pricing loan products on the basis of market benchmark in a transparent manner. Indian Banks’ Association is to advise banks on the benchmark PLR keeping in view the operational requirement. 3. Credit Delivery Mechanism Credit Facilities for Small Scale Industries: In order to improve the flow of credit to small scale industries (SSIs), it was proposed that banks may, on the basis of good track record and the financial position of the SSI units, increase the loan limit from Rs.15 lakh to Rs.25 lakh (with the approval of their Boards) for dispensation of collateral requirement. It was further proposed that (i) the interest rate on the deposits of foreign banks placed with SIDBI towards their priority sector shortfall will be at the Bank Rate, (ii) SIDBI will take appropriate steps to ensure that priority sector funds are utilised expeditiously and benefits of reduction in interest rates are passed on to the borrowers. Finally, it was proposed that all new loans granted by banks to NBFCs for the purpose of on-lending to SSI sector would also be reckoned for priority sector lending. Micro-finance: Considering the recommendations of the four informal groups constituted to examine issues concerning micro-finance delivery, it was proposed that banks should provide adequate incentives to their branches in financing the self help groups (SHGs) and establish linkage with them. The approach to micro-finance to SHGs should be totally hassle-free and may include consumption expenditures to enable smoothing of consumptions as needed relative to time-profile of income flows. 4. Money Market Moving towards Pure Inter-bank Call/Notice Money Market: In view of further market developments as also to move towards a pure inter-bank call/notice money market, it was proposed that with effect from the fortnight beginning December 27, 2003, non-bank participants would be allowed to lend, on average in a reporting fortnight, up to 60 per cent of their average daily lending in the call/notice money market during 2000-01, down from 75 per cent announced in April 2003. Rationalisation of Standing Facilities: In order to move further towards phasing out sector-specific standing facilities as also to rationalise the rates at which liquidity is injected into the system, it was proposed that the "normal" and "back-stop" standing facilities will be available in the ratio of one-third to two-thirds (33:67) from the fortnight beginning December 27, 2003 as against the prevailing ratio of 50:50. Primary Dealers’ Access to Call/Notice Money Market: With a view to further develop the repo market as also to ensure a balanced development of various segments of money market, it was proposed that with effect from February 7, 2004, PDs will be allowed to borrow, on average in a reporting fortnight, up to 200 per cent of their net owned funds as at end-March of preceding financial year. 5. Foreign Exchange Market (a) Unhedged Forex Exposures of Corporates: It was decided that all foreign currency loans by banks above US $ 10 million can be extended to corporates only on the basis of a well laid out policy of the Board to ensure hedging, except for loans to finance exports and for meeting forex expenditure. (b) Export Follow–up: Beginning January 1, 2004, all exporters may write-off outstanding export due on their own and may also extend the renewal period of realisation beyond 180 days on their own up to 10 per cent of their export proceeds in a calendar year. (c) Issue of Units of Mutual Fund – General Permission: In order to provide single window clearance to Indian Asset Management Companies (AMCs) who launch off-shore funds abroad, in consultation with SEBI, it was proposed to accord general permission to AMCs to issue units, remit dividend and redeem the units issued, once SEBI’s approval is obtained for launching off-shore funds, subject to reporting requirements. 6. Prudential Measures (a) Prudential Norms for FIs: To harmonise the asset classification norms of FIs and banks, in line with international norms, it was proposed to adopt the 90-day norm for recognition of loan impairment for FIs from the year ending March 31, 2006. (b) Monitoring of Systemically Important Financial Intermediaries (SIFIs): In consultation with the Chairman, SEBI and Chairman, IRDA, it was decided to establish a special monitoring system in respect of SIFIs that would encompass (i) a reporting system for SIFIs on financial matters of common interest to the Reserve Bank, SEBI and IRDA; (ii) the reporting of intra-group transactions of SIFIs; and (iii) the exchange of relevant information among the Reserve Bank, SEBI and IRDA. (c) Corporate Governance: It was proposed to harmonise the approaches suggested by the Ganguly Committee and the SEBI Committee in regard to corporate governance by banks, and to extend such practices to PDs, NBFCs and other financial institutions.

Frauds

2.26 The notable features in respect of frauds during 2002-03 were the following:

• During July-December 2002, commercial banks reported 1,597 cases of frauds involving Rs.267 crore; during July-June 2001-02, 2,253 cases of frauds involving Rs.414 crore were reported by commercial banks.
• During July-March 2002-03, 69 caution advices were issued to commercial banks (except RRBs) in respect of firms / companies committing serious irregularities in their borrowal accounts; during July-June 2001-02, 81 caution advices were issued for alerting commercial banks (except RRBs) against fraudulent operations of certain unscrupulous elements.
• During July-December 2002, 40 cases of robberies / dacoities involving Rs.280 crore were reported by PSBs; during July-June 2001-02, 118 cases involving Rs.596 crore of robberies / dacoities were reported.

Computerisation of Fraud-related Information System

2.27 A module on fraud monitoring and reporting system was developed by the Reserve Bank and forwarded to banks. From the quarter ending June 2003, banks are required to submit a number of frauds and vigilance returns through this module to the Reserve Bank.

Committees related to Banking Supervision

Guidelines on Consolidated Accounting and Supervision of Banks and FIs

2.28 In view of the sharper focus on empowering supervisors to undertake consolidated supervision of bank groups and since the Core Principles for Effective Banking Supervision have underscored this requirement as an independent principle, the Reserve Bank set up a multi-disciplinary Working Group in November 2000 (Chairman: Shri Vipin Malik). The Working Group examined the feasibility of introducing consolidated accounting and other quantitative methods to facilitate consolidated supervision. Based on the recommendations of this Working Group, guidelines were issued to banks on February 25, 2003 and FIs on August 1, 2003.

2.29 Initially, consolidated supervision has been mandated for all groups where the controlling entity is a bank. All banks that come under the purview of consolidated supervision of the Reserve Bank have been advised to prepare and disclose Consolidated Financial Statements (CFS) from the financial year commencing from April 1, 2002, in addition to their single financial statements. The CFS are to be prepared in accordance with the Accounting Standard 21 (related to CFS) and other related Accounting Standards prescribed by the Institute of Chartered Accountants of India (ICAI), viz., Accounting Standards 23 (relating to Investments in Associates in CFS) and 27 (financial reporting of investment in joint ventures). In addition, banks are presently required to prepare Consolidated Prudential Reports (CPR). These reports have been initially introduced on a half-yearly basis from March 31, 2003 as part of the off-site reporting system on the lines of the existing off-site returns for banks. The banks are expected to prepare the CPR adopting the same principles as laid down in Accounting Standards 21, 23 and 27. However, since there is a possibility of including mixed conglomerates in due course, to start with, CPR is expected to contain information and accounts of related entities which carry on activities of banking or financial nature and need not include related entities engaged in insurance or business not pertaining to financial services.

2.30 For the purpose of application of prudential norms on a group-wide basis, the prudential norms / limits, such as, capital to risk-weighted asset ratio (CRAR), single / group borrower exposure limits, liquidity ratios, mismatches limits and capital market exposure limits have also been prescribed for compliance by the consolidated bank.

Working Group Relating to Empanelment of Statutory Auditors

2.31 The Working Group constituted to review and suggest modifications in the existing norms for empanelment of audit firms to be appointed as statutory auditors of PSBs, seven all-India FIs and the Reserve Bank submitted its report on March 12, 2003. The recommendations of the Group were approved with certain modifications by the Audit Sub-Committee of the BFS in its meeting held on April 25, 2003. The revised norms and other recommendations will be implemented with effect from the year 2004-05. The major recommendations of the Working Group for eligible audit firms are:

• minimum seven full-time chartered accountants with the firm (as against six) of which five should be full-time partners, each with a minimum continuous association of 15,10, 5, 5 and 1 year, respectively, with the firm;
• a professional staff of 18 (as against 15 in the existing norms); a minimum standing of 15 years (as against 10 years in the existing norms);
• a minimum statutory bank / branch audit experience of 15 years (as against 8 years in the existing norms); and
• at least one partner or paid chartered accountant with Certified Information Systems Auditor (CISA) / ISA or any other equivalent qualification.

Checklist for Computer Audit

2.32 An assessment of the system of computer audit in banks was made based on the findings of the inspection reports of banks for the years 1998-99 and 1999-2000. In this context, the following specific feedback received from banks was taken into account, viz., nature of the Information Technology (IT) management function, IT risk management, electronic data processing (EDP) audit systems, EDP audit methodology, and other related matters. It was evident from the assessment that the computer audit in India was still in a nascent stage and a major constraint encountered by banks has been the general shortage of skilled technical personnel for the task. The findings of the assessment were considered by the Audit SubCommittee of the BFS, which directed the constitution of a committee to examine the aspects related to computer audit in detail. It was also decided to draw up a checklist in a standardised form so that all banks operating in the country can ensure that their computerised branches put in place requisite controls in the computerised environment and that the branch auditors also verify the same and incorporate their observation in the report. Accordingly, a committee was constituted comprising representatives of the Reserve Bank, ICAI and a few select banks. The Committee recommended that the internal security audit checklist needed to be platform independent, while the necessary platform dependent control questionnaire could be framed by the banks themselves. The Committee classified the risk areas into 15 categories and prepared checklists in respect of each of the areas² . It is expected that these checklists would serve as a minimum standard in conducting computer audit in banks and FIs.

2.33 The main purpose for preparing checklists for conducting computer audit was to sensitise banks on the emerging concerns arising on account of computerisation and growing dependence on computers and technology for conducting business. The checklists, as approved by the Audit Sub-Committee of the BFS, were forwarded to banks and FIs in December 2002.

Supervisory Policy Developments

Quarterly Review

2.34 Currently, only half-yearly results of listed companies are subjected to limited review by the auditors. The Securities and Exchange Board of India (SEBI) made an amendment in January 2003 to clause 41 (related to half-yearly limited review of listed companies) of the Listing Agreement to make it mandatory for all listed companies (including commercial banks) to get their quarterly results subjected to "limited review" by the auditors of the company (or by a Chartered Accountant in case of public sector undertakings) and a copy of the Review Report is required to be submitted to the Stock Exchanges. It has been decided by the Audit

Sub-Committee of the BFS that such quarterly review should be carried out by the listed public sector banks also, on the same lines of half-yearly limited review, with effect from the quarter ended June 30, 2003.

Prompt Corrective Action

2.35 A system of Prompt Corrective Action (PCA), based on a pre-determined rule-based structured early intervention, has been put in place with effect from December 2002 as a part of ongoing efforts to enhance the existing supervisory framework. The Reserve Bank will initiate certain structured action in respect of banks which will hit trigger points in terms of three parameters, viz., (a) CRAR, (b) ratio of net NPAs to net advances, and (c) return on assets. It was decided that PCA scheme may be put into operation, initially for a period of one year from December 2002. The scheme was circulated among banks on December 21, 2002, advising them to take steps to ensure that they do not come under the provisions of PCA. Banks were also advised to place the scheme before their Board of Directors. It was also decided that the banks, which have already breached the trigger points under the PCA scheme, will be advised of the specific actions to be taken by them separately. Such banks were also cautioned of the impending actions. A review of the scheme is envisaged in December 2003.

Risk-Based Supervision

2.36 After having put in place the essential aspects of risk-based supervision (RBS) during 2001-02, the implementation of the RBS approach was taken up in phases during 2002-03. For ensuring a smooth transition to risk-based supervision of banks, the new RBS Manual has been prepared keeping in view international best practices customised to suit the Indian conditions. For compiling risk profiles of banks, the detailed risk profile template was designed for use by the Reserve Bank supervisory staff. Similar templates were designed for use of banks and forwarded to them for self-assessment of risks taken by them. In order to create greater awareness among bank professionals, training programmes on risk management and risk-based supervision are being conducted in the Reserve Bank training establishments on an ongoing basis since June 2002.

2.37 A Discussion Paper was issued in August 2001 to familiarise banks with the RBS approach. The paper also identified five areas of action for the commercial banks, viz., (a) putting in place appropriate risk management architecture, (b) setting up of risk-based internal audit function, (c) upgrading management information and information technology systems, (d) undertaking human resource initiatives, and (e) setting up of dedicated compliance units necessary for adoption of the RBS approach. As part of the consultative process, high-level meetings were held with banks to identify issues on which they required further guidance / assistance from the Reserve Bank in the process of transition. Guidance notes on credit risk management, market risk management and risk based internal audit were issued to banks. Banks were advised to put in place an institutional mechanism to monitor the progress in preparedness for RBS, which is being reviewed by the Reserve Bank through periodic returns received from them and also by holding periodic meetings with them.

2.38 Eight banks, representing a mix of banks in the public sector, private sector and foreign banks have been identified for the implementation of RBS on a pilot basis. The compilation of risk profiles of the selected banks has commenced at Regional Offices of the Reserve Bank. Based on individual risk profiles, customised supervisory programme, together with bank-level action, will be prepared for each of the select banks. The customised programme will include the identified supervisory cycle for the bank, the intensity of supervision to be exercised and the mix of supervisory tools, including the RBS on-site inspection, to be applied for addressing the concerns identified in the risk profile.

2.39 The pilot RBS inspections of the select banks will be taken up independently after the annual financial inspections of these banks are completed under the present inspection system based on Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Systems (CAMELS) for the domestic banks, and an inspection system based on Capital Adequacy, Asset Quality, Liquidity, Compliance and Systems (CALCS) for the foreign banks. Under RBS, on-site inspections will be targeted to the areas of concern, which warrant on-location examination as revealed from the risk profile. On the basis of the experience gained in the pilot exercise the approach to RBS will be further fine-tuned and is likely to be extended to all banks in due course.

Changes in the Off-Site Monitoring and Surveillance System

2.40 After the introduction of Off-Site Monitoring and Surveillance (OSMOS) system in 1995, the scope and coverage of the off-site returns have been enhanced significantly. In view of the recent initiatives on consolidated supervision, country risk management and risk-based supervision, certain additional data needed to be collected through off-site returns. Accordingly, an upgraded OSMOS system, including new returns as well as enhancing the coverage of the existing ones, has been implemented from the quarter ended June 2003.

Supervisory Rating of Banks

2.41 Keeping in view the importance of monitoring and prevention of frauds, it was decided that compliance in this area should carry more weight while rating the banks. Accordingly, some changes were made in the system of rating banks under CAMELS / CALCS models wherein compliance regarding fraud monitoring and prevention would carry more weight.

Risk Based Internal Audit

2.42 The guidelines relating to risk-based internal audit systems were issued to banks in December 2002 wherein they were advised to immediately initiate necessary steps to review their current internal audit systems and prepare for the transition to a risk-based internal audit system in a phased manner, keeping in view their risk management practices, business requirements and manpower availability.

Prudential Norms

(a) Exposure Norms

Measurement of Credit Exposure on Derivative Products

2.43 Credit exposures on derivative products have important ramifications for banks. Consequently, it is crucial that these are measured appropriately. As per the instructions, prior to March 31, 2003, exposures by way of non-funded credit limits were captured at 50 per cent of such limits or outstandings, whichever is higher. Besides, the exposure of banks on derivative products, such as, Forward Rate Agreements (FRAs) and Interest Rate Swaps (IRS) was captured for computing exposure by applying the conversion factors to notional principal amounts as per the original exposure method. With effect from April 1, 2003, in addition to reckoning non-fund based limits at 100 per cent, banks have been advised to include forward contracts in foreign exchange and other derivative products at their replacement cost value in determining individual / group borrower exposure. As per the paper of the Basel Committee on Banking Supervision on International Convergence of Capital Measurement and Capital Standards, 1988, there are two methods to assess the exposure on account of credit risk in derivative products, viz., (i) Original Exposure Method, and (ii) Current Exposure Method (Box II.2). Banks and FIs have been encouraged to follow the Current Exposure Method, which is more accurate in measuring credit exposure of a derivative product. In case a bank is not in a position to adopt the Current Exposure Method, it may follow the Original Exposure Method. However, banks have been advised that their endeavour should be to move over to the Current Exposure Method in course of time. Banks have been advised to adopt, effective from April 1, 2003, either of the above two methods, consistently for all derivative products, in determining individual / group borrower exposure. Banks would not be required to calculate potential credit exposure for single currency floating/floating interest rate swaps. The credit exposure on single currency floating / floating interest rate swaps are to be evaluated solely on the basis of their mark-to-market value.

Box II.2 : Measurement of Credit Risk Exposure of Derivative Products There are two methods for measuring the credit risk exposure inherent in derivatives, as described below. 1. The Original Exposure Method Under this method, the credit risk exposure of a derivative product is calculated at the beginning of the derivative transaction by multiplying the notional principal amount with the prescribed credit conversion factor. This method, however, does not take account of the ongoing market value of a derivative contract, which may vary over time. In order to arrive at the credit equivalent amount, a bank should apply the following credit conversion factors to the notional principal amounts of each instrument according to the nature of the instrument and its original maturity: 2. The Current Exposure Method Under this method, the credit risk exposure / credit equivalent amount of the derivative products is computed periodically on the basis of the market value of the product to arrive at its current replacement cost. Thus, the credit equivalent of the off-balance sheet interest rate and exchange rate instruments would be the sum of the following two components: (a) the total ‘replacement cost’ - obtained by marking-to-market all the contracts with positive value (i.e., when the bank has to receive money from the counterparty); and (b) an amount for ‘potential future changes in credit exposure’ - calculated by multiplying the total notional principal amount of the contract by the following credit conversion factors according to the residual maturity of the contract: Original Conversion Factor   Residual Conversion Factor Maturity to be applied on   Maturity to be applied on   Notional Maturity     Notional Maturity   Principal Amount     Principal Amount   (per cent)     (per cent)   Interest Exchange     Interest Exchange   Rate Rate     Rate Rate   Contract Contract     Contract Contract Less than one year 0.5 2.0   Less than one year Nil 1.0 One year and less than two years 1.0 5.0 (i.e., 2+3)   One year and over 0.5 5.0 For each additional year 1.0 3.0         Reference : Basel Committee on Banking Supervision (1988), International Convergence of Capital Measurement and Capital Standards, Bank for International Settlements, basel

Guidelines on Infrastructure Financing

2.44 In view of the critical importance of the infrastructure sector and high priority being accorded for development of various infrastructure services, infrastructure financing by banks was reviewed in consultation with Government of India and revised guidelines on financing of infrastructure projects were issued in February 2003. Accordingly, any credit facility in whatever form extended by lenders (i.e.,Basel. banks, FIs or NBFCs) to an infrastructure facility as broadly defined in the guidelines would be treated as ‘infrastructure lending’. Specifically, a credit facility provided to a borrower company engaged in developing, or operating and maintaining, or developing, operating and maintaining any project in any of the following sectors would qualify as infrastructure facility:

• a road, including toll road, a bridge or a rail system;
• a highway project, including other activities being an integral part of the highway project;
• a port, airport, inland waterway or inland port;
• a water supply project, irrigation project, water treatment system, sanitation and sewerage system or solid waste management system;
• telecommunication services whether basic or cellular, including radio paging, domestic satellite service (i.e., a satellite owned and operated by an Indian company for providing telecommunication service) and network of trunking, broadband network and internet services;
• an industrial park or special economic zone;
• generation or generation and distribution of power;
• transmission or distribution of power by laying a network of new transmission or distribution lines; and
• Any other infrastructure facility of similar nature.

2.45 In terms of the existing guidelines, credit exposure to borrowers belonging to a group may exceed the prudential exposure norm of 40 per cent of the bank’s capital funds by an additional 10 per cent (i.e., up to 50 per cent), provided the additional credit exposure is on account of extension of credit to infrastructure projects. In addition to the above, credit exposure to single borrower may exceed the prudential exposure norm of 15 per cent of the bank’s capital funds by an additional 5 per cent (i.e., up to 20 per cent) provided the additional credit exposure is on account of infrastructure lending. Banks may assign a concessional risk weight of 50 per cent for capital adequacy purposes on investment in securitised paper pertaining to an infrastructure facility which complies with certain conditions specified in the revised guidelines.

Norms for Foreign Banks

2.46 Effective March 31, 2002, foreign banks were brought on par with Indian banks for the purpose of computing the prudential credit exposure ceiling by broadening the concept of ‘capital funds’ as regulatory capital (i.e., Tier I and Tier II capital) in India as defined under the capital adequacy standards. Consequent upon the adoption of the revised concept of capital funds, some foreign banks’ exposures to individual / group borrowers exceeded the prudential exposure limits. Foreign banks are now not allowed to assume fresh exposure to single / group borrowers beyond the prudential credit exposure limits.

2.47 With a view to smoothening the transition to prudential exposure limits, relaxations were allowed in respect of the following:

• In case of merger / acquisition of different borrowing companies, foreign banks may continue with the excess group exposure till March 31, 2004 if their group exposure exceeds the prudential norm; and
• The existing fund and non-fund based facilities, such as, term loans, investments in bonds / debentures and performance guarantees, etc., exceeding the exposure ceilings, may continue till their expiry / maturity.

Underwriting by Merchant Banking Subsidiaries of Commercial Banks

2.48 Banks / subsidiaries were, hitherto, required to ensure that the funded and non-funded commitments, including investments and devolvements emanating from underwriting and other commitments (like stand-by facilities relating to a single legal person or entity) did not exceed 15 per cent of the net owned funds of the bank / subsidiary and the commitments under a single underwriting obligation did not exceed 15 per cent of an issue. These guidelines were reviewed and with a view to providing a level playing field to the merchant banking subsidiaries of banks, it was decided that the existing ceiling on underwriting commitments would not be applicable to them. The merchant banking subsidiaries of banks regulated by the SEBI would, consequently, be governed by the SEBI norms on various aspects of the underwriting exercise taken up by them. The prudential exposure ceiling on underwriting and similar commitments of banks, however, remained unchanged and would continue to be reckoned within the norms prescribed by the Reserve Bank earlier on overall borrower / issue size limits from time to time.

Advances to Self-Help Groups against Group Guarantee

2.49 At present, banks are required to limit their commitment by way of unsecured advances in such a manner that 20 per cent of the banks’ outstanding unsecured guarantees together with a total of outstanding unsecured advances do not exceed 15 per cent of their total outstanding advances.

2.50 Banks generally lend to Self-Help Groups (SHGs) against group guarantees without insisting on any security. Considering the high recovery rate in respect of banks’ advances to SHGs and that this programme helps the poor, banks were advised in November 2002 that unsecured advances given by them to SHGs against group guarantee would be excluded for the purpose of computation of the prudential norms on unsecured guarantees and advances until further notice. The matter would be reviewed after a year in the light of growth in aggregate unsecured advances, and the recovery performance of advances to SHGs.

(b) Capital Adequacy

Basel II Developments

2.51 The New Basel Capital Accord, popularly known as Basel II, is being operationalised sometime around end-2006. The Accord represents the convergence of research and practice in supervision as it attempts to apply state-of-the-art financial modelling techniques to the prescription of capital adequacy. The Third Consultative Paper (CP 3) of the Basel Committee on Banking Supervision (BCBS) was released in April 2003 for comments by interested parties and national central banks. The Reserve Bank forwarded its comments on CP3 to BCBS in July 2003 (Box II.3).

Box II.3: The Third Consultative Paper (CP3) on the New Basel Capital Accord and Comments of the Reserve Bank The Basel Committee on Banking Supervision (BCBS) released the Third Consultative Paper (CP3) on the New Basel Capital Accord (Basel II) in July 2003. In view of the aim of BCBS to finalise Basel II by end of 2003 with operationalisation expected by end-2006, CP3 is an important development. The CP3 document is a culmination of the comments received from more than 40 countries on the third Quantitative Impact Study (QIS3) held in October 2002. In response to the comments received from QIS3 technical guidance, the following significant modifications have been proposed in the new Accord: Fully secured lending (by mortgages on residential property that is or will be occupied by the borrower) will now receive a 35 per cent risk weighting in the standardised approach instead of the earlier 40 per cent. If a bank estimates its own loss given defaults (LGDs), where those estimates are volatile over the economic cycle, LGDs that are appropriate for an economic downturn should be used. A minimum LGD value of 10 per cent is proposed for retail exposures secured by mortgages. As an alternative to standard or own estimate haircuts for repo style transactions the method of Value at Risk (VaR) has been confirmed. In this context, the methodology of Backtesting has now been developed. Advanced and Foundation Internal Rating-based (IRB) approaches are presently available for high volatility commercial real estate lending. These are similar to the general IRB approaches to corporate lending, except that a separate risk weight function is used. A revolving retail exposures risk weight curve has been recalibrated in the light of QIS3 results. An alternative standard operational risk approach has been developed. The basic comments of the Reserve Bank on the CP3 are as follows: All banks with cross-border business exceeding 20 to 25 per cent of their total business may be defined as internationally active banks. The Basel Committee may consider prescribing a material limit (up to 10 per cent of the total capital) up to which cross-holdings of capital and other regulatory investments could be permitted and any excess investments above the limit would be deducted from total capital. Only those Export Credit Agencies (ECAs) would be eligible for use in assigning preferential risk weights which, (a) disclose publicly their risk scores, rating process and procedure, (b) subscribe to the publicly disclosed OECD methodology, and (c) are recognised by national supervisors. Risk weighting of banks should be de-linked from the credit rating of sovereigns in which they are incorporated. It would be difficult for supervisors to take a view as to whether the External Credit Assessment Institutions (ECAIs) are using unsolicited ratings to put pressure on entities to obtain solicited ratings. Supervisors are neither equipped nor competent to identify such behaviour of rating agencies. While internationally active banks in emerging economies may initially be required to follow the Standardised Approach, they may be allowed to use the internal ratings for assigning preferential risk weights on certain types of exposures, after validation of the internal rating systems by national supervisors. There is a strong case for revisiting the risk weights assigned to sovereign exposures when the exposures are aggregated as a portfolio which enjoy the benefits of diversification similar to the approach adopted for retail procedures. The capital charge for specific risk in the banking and trading books should be consistent to avoid regulatory arbitrages. References: Bank for International Settlements (2003), Third Consultative Paper, Basel. Reserve Bank of India (2003), Comments of the RBI on the Third Consultative Document of the New Basel Capital Accord, Mumbai.

Investment Fluctuation Reserve

2.52 With a view to building up of adequate reserves to guard against any possible reversal in the interest rate environment in future due to unexpected developments, banks were advised to build up an Investment Fluctuation Reserve (IFR) of a minimum of 5 per cent of the investment held in the Available for Sale (AFS) and Held for Trading (HFT) categories of the investment portfolio within a period of five years commencing from the year ended March 31, 2002. As suggested by banks and to give further relaxation in building IFR, it was decided that while IFR would continue to be treated as Tier II capital, it would not be subject to the ceiling of 1.25 percent of the total risk-weighted assets. However, for the purpose of compliance with the capital adequacy norms, Tier II capital including IFR would be considered up to a maximum of 100 per cent of total Tier I capital. The above treatment would be effective from March 31, 2003 onwards.

(c) Income Recognition / Asset Classification

Projects under Implementation involving Time Overrun

2.53 Banks were advised in May 2002 that the projects under implementation would be grouped under the following three categories for determining the date when the project ought to be completed and the manner in which the asset classification of the underlying loan should be determined:

• Projects where financial closure had been achieved and formally documented may be treated as standard assets for a period not exceeding two years, beyond the date of completion of the project (as originally envisaged at the time of initial financial closure of the project).
• Projects sanctioned before 1997, with an original project cost of Rs.100 crore or more, where financial closure was not formally documented, and where the deemed date of completion of the project has been decided by an independent group of outside experts may be treated as a standard asset for a period not exceeding two years, beyond the deemed date of completion of the project, as decided by the Group.
• Projects sanctioned before 1997, with original project cost of less than Rs.100 crore where financial closure was not formally documented, may be treated as standard assets only for a period not exceeding two years, beyond the date of completion of the project (as originally envisaged at the time of sanction).
• In February 2003, banks were allowed to recognise income on accrual basis in respect of the above three categories of projects under implementation which are classified as ‘standard’ in terms of the above guidelines.

Recovery of Agricultural Loans affected by Natural Calamities

2.54 The year 2002 witnessed one of the worst droughts. As part of relief measures, the Reserve Bank advised banks in November 2002 not to effect recovery of any amount either by way of principal or interest during that financial year in respect of Kharif crop loans in the districts affected by failure of the South-West monsoon as notified by the State Governments. Further, the principal amount of crop loans in such cases should be converted into term loans and will be recovered over a period of minimum five years in case of small and marginal farmers, and four years in case of other farmers. Interest due in financial year 2002-03 on crop loans should be deferred and no interest should be charged on the deferred interest.

2.55 Banks were advised that in such cases of conversion or re-scheduling of crop loans into term loans, the term loans may be treated as current dues and need not be classified as NPA. The asset classification of these loans would thereafter be governed by the revised terms and conditions and would be treated as NPA, if interest and / or instalment of principal remain unpaid for two harvest seasons, not exceeding two half years.

(d) Provisioning Norms

Inter-branch Accounts

2.56 Banks were advised to make 100 per cent provision from the year ended March 31, 1999 for the net debit position in their inter-branch accounts, arising out of the unreconciled debit and credit entries outstanding for more than three years as on March 31 every year. The period was reduced to two years from the year ended March 31, 2001 and further to one year from the year ended March 31, 2002. Banks are required to reconcile the entries in their inter-branch accounts within a period of six months. With this objective in view and in keeping with the best banking practices, it was decided that with effect from the year ending March 31, 2004, banks would be required to make 100 per cent provision for the net debit position in their inter-branch accounts in respect of entries which are un-reconciled and outstanding for more than six months.

2.57 With a view to reducing the level of long pending outstanding entries in the clearing adjustment accounts of banks, they have been allowed as a one-time measure, to net off the entries representing ‘clearing differences -receivable’ against entries representing ‘clearing differences - payable’ up to Rs.500 which are outstanding for more than three years as on March 31, 2003.

Accounting Standards

2.58 A Working Group (Chairman: Shri N.D. Gupta) was constituted to recommend steps to eliminate/reduce gaps in compliance by banks with Accounting Standards (AS) as issued by ICAI. The Working Group examined compliance by banks with the AS 1 to 22, which were already in force for the accounting period commencing from April 1, 2001, as also AS 23 to 28, which were to come into force for subsequent periods. The Working Group observed in its Report, that out of Accounting Standards which are already in force, viz., AS 1 to 22, banks in India are generally complying with most of the AS, except the following eight, leading to qualification in the financial statement. These pertain to AS 5 (net profit or loss for the period, prior period items and changes in accounting policies), AS 9 (revenue recognition), AS 11 (accounting for the effect of changes in foreign exchange rates), AS 15 (accounting for retirement benefits in the financial statements of employers), AS 17 (segment reporting), AS 18 (related-party disclosures), AS 21 (consolidated financial statements) and AS 22 (accounting for taxes on income).

2.59 In view of the above and also with a view to eliminating gaps in compliance with the AS, the Working Group made certain recommendations for compliance by banks with the concerned accounting standards. The Working Group has not made any recommendation on AS 11 (accounting for effects of changes in foreign exchange rates), since the ICAI was in the process of revising the concerned accounting standard. In March 2003, the Reserve Bank issued detailed guidelines on the basis of the Group’s recommendations for the guidance of the banks.

Other Structural and Regulatory Changes

Setting up of New Private Sector Banks

2.60 With a view to impart greater competition in the banking system the Reserve Bank had set up a committee in January 1998 to review the licensing policy for setting up new private sector banks. Subsequently, the Reserve Bank issued guidelines for entry of new banks in the private sector in January 2001.

2.61 The applications received by the Reserve Bank within the stipulated period were scrutinised to ensure prima facie eligibility and thereafter referred to a High-Level Advisory Committee (Chairman: Dr.I.G. Patel) set up by the Reserve Bank. In their Report submitted to the Reserve Bank in June 2001, the Committee had recommended two applications as suitable for issue of ‘in-principle’ approvals for setting up new banks in private sector. The applications recommended were from Shri Ashok Kapur and two other banking professionals with Rabobank Netherlands, and Kotak Mahindra Finance Ltd., a non-banking financial company.

2.62 ‘In principle’ approvals to the above two applicants, valid for one year, were issued on February 7, 2002. On being satisfied that the Kotak Mahindra Finance Ltd. complied with the requisite conditions laid down by the Reserve Bank as part of the ‘in-principle’ approval, they were granted a licence for commencement of banking business under Section 22 (1) of Banking Regulation Act, 1949 on February 6, 2003. The bank commenced operations with effect from March 22, 2003 and was included in the Second Schedule to the Reserve Bank of India Act, 1934 with effect from April 12, 2003. The other applicant has been granted extension of time till November 30, 2003 to complete all necessary formalities and to commence banking operations.

Foreign Direct Investment in the Banking Sector

2.63 The Finance Minister announced in the Union Budget 2003-04 that the limit for foreign direct investment in banking companies would be raised from 49 per cent to 74 per cent, to facilitate setting up of subsidiaries by foreign banks and for attracting investments in private sector banks. Accordingly, the Reserve Bank has proposed to the Government of India to lift the limit of voting rights. Even though comprehensive amendments to the Banking Regulation Act, 1949 are under active consideration of the Government and the Reserve Bank, an amendment to Section 12 of the Banking Regulation Act, 1949 (relating to voting rights of shareholders, among others) was suggested as an immediate measure to facilitate investment in private sector banks up to 74 per cent as envisaged in the Union Budget.

Setting Up of Off- Shore Banking Units

2.64 Following the announcement in the EXIM Policy 2002-07 by the Government of India, the Reserve Bank issued guidelines in November 2002 allowing banks operating in India to set up Off-Shore Banking Units (OBUs) in Special Economic Zones (SEZs) which would be virtually foreign branches of Indian banks located in India. The salient features of the scheme for setting up OBUs in SEZs are:

• All banks operating in India, authorised to deal in foreign exchange, are eligible to set up OBUs, with a preference for banks having overseas branches and experience of running OBUs.
• Banks would be required to obtain prior permission of the Reserve Bank for opening an OBU in a SEZ under Section 23(1)(a) of the Banking Regulation Act, 1949 (relating to opening of new place of business in India).
• Since OBUs would be branches of Indian banks, no separate assigned capital for such branches would be required. However, with a view to enabling them to start their operations, the parent bank would be required to provide a minimum of US $10 million to its OBU.
• The Reserve Bank would grant exemption from CRR requirements to the parent bank in respect of its OBU branch.
• The sources of raising foreign currency funds would only be external.
• The OBUs would be required to follow scrupulously ‘Know Your Customer’ and other anti-money laundering instructions issued by the Reserve Bank.
• The OBUs would be required to maintain separate nostro accounts with correspondent banks, which would be distinct from nostro accounts maintained by other branches of the same bank.
• Deposits of OBUs will not be covered by deposit insurance.
• The loans and advances of OBUs would not be reckoned as net bank credit for computing priority sector lending obligations.

Guidelines on Lenders’ Liability Laws

2.65 Based on the recommendations of a Working Group constituted by the Government of India on Lenders’ Liability Laws, banks and all-India FIs were advised on May 5, 2003 to adopt prescribed broad guidelines and frame the Fair Practices Code duly approved by their Board of Directors. The Fair Practices Code is expected to improve the quality of banking services to borrowers by making their own service obligations more transparent. The salient features of the guidelines are as follows:

• Loan application forms in respect of priority sector advances (up to Rs.2 lakh) should include information such as fees / charges payable for processing and pre-payment options.
• Banks and FIs should devise a system of giving acknowledgement for receipt for all loan applications.
• In case of rejection of applications of small borrowers seeking loans up to Rs.2 lakh, the main reason(s) for rejection should be conveyed in writing within the stipulated time.
• Lenders should ensure proper assessment of credit application by borrowers. The margin and security stipulation should not be used as a substitute for due diligence on creditworthiness of the borrower.
• Lenders should ensure timely disbursement of loans sanctioned in conformity with the terms and conditions governing such sanction, give notice of any change in the terms and conditions, including interest rates and service charges and ensure that changes in interest rates and charges are effected only prospectively.
• Post-disbursement supervision by lenders, particularly in respect of loan up to Rs.2 lakh, should be constructive with a view to taking care of any genuine difficulty that the borrower may face.
• Lenders should refrain from interference in the affairs of borrowers except for what is provided in the terms and conditions of the loan sanction documents.
• Consent or objection to a request for transfer of borrowal account, either from the borrower or from a bank / FI, should be conveyed within 21 days from the date of receipt of request.

4. Risk Management

2.66 In order to reap the benefits of financial market development and ensure financial sector stability, the risks introduced by each market need to be effectively managed before other markets are developed and more risks are injected into the financial system. The market development strategy, therefore, needs to accord priority to mitigate the risks introduced by more sophisticated financial markets and the risks to macroeconomic control from institutional reforms. The taxonomy of risks facing the four major financial markets: money, debt, equity and foreign exchange and the measures to mitigate them are delineated in Box II.4.

Bank Financing of Equities and Investment in Shares

2.67 In view of the increasing importance of efficiency of the risk management systems, banks were advised to review more specifically their risk management systems pertaining to capital market exposures and exposures to stock broking entities / market makers. The review, which is to be placed before the Board of Directors, should, inter alia, assess the efficiency of the risk management systems in place in the bank, assess the extent of compliance with the guidelines issued and identify the gaps in compliance for initiating appropriate steps immediately.

Guidelines on Country Risk Management

2.68 With a view to furthering compliance with the Core Principles for Effective Banking Supervision, released by the BIS in 1997, the Reserve Bank has framed guidelines on country risk management and provisioning. These guidelines were issued to banks on February 19, 2003 (Box II.5).

Management of Operational Risk

2.69 Operational risk covers a broad range of risks that are internal to the bank. Operational risk arises out of deficiencies in the internal systems, control systems failures and non-adherence to prescribed procedure. In recent years, size of operation of banks have increased manifold. Besides, banks are diversifying into various para-banking activities. Due to increased exposure of banks to various sectors and activities, the risks associated with them have also increased. Managing operational risk has, thus, gained importance with the change in the scale of banking operations. The nature and scope of operational risks has also received an added importance in view of the Basel II requirements (Box II.6).

Guidance Notes on Management of Credit and Market Risks

2.70 Guidelines on risk management systems were issued to banks in October 1999. These, together with the asset-liability management (ALM) guidelines issued earlier in February 1999, have been intended at providing a benchmark to the banks which were yet to establish integrated risk management systems. As a step towards enhancing and fine-tuning the existing risk management practices in banks, draft guidance notes on management of credit risk and market risk based on the recommendations of two Working Groups constituted in the Reserve Bank drawing experts from select banks and FIs were issued and also placed on the Reserve Bank’s website for wider discussion by banks, FIs and other market participants during 2001-02.

2.71 With regard to credit risk, the guidance note covers areas pertaining to the policy framework, the types of credit risk models, managing credit risk in inter-bank and off-balance sheet exposures and implications for credit risk management arising from the New Capital Accord. With regard to market risk, the guidance note encompasses areas of liquidity, interest rate risk and foreign exchange risk management as well as the treatment of market risk in the proposed New Capital Accord. Issues like Value-at-Risk and stress-testing have also been dealt with in the guidance note. These draft guidance notes were subsequently revised in the light of the feedback received and the revised Guidance Notes issued to banks were placed on the website of the Reserve Bank in October

Box II.4: Necessary Measures for Mitigating Select Risks in Major Financial Markets Source and Type of Risk Money Market Debt Securities Market Equity Market Foreign Exchange Market Credit Risk Detailed financial information disclosure on asset quality, capital adequacy and liquidity position. Improve credit pricing ability by standardising bond contracts, requiring the use of rating agencies.   —   Conduct detailed credit analysis on borrowers, with a special focus on foreign currency earning and exchange risk hedging capacities.                                   Enhance credit risk analysis.               Apply high underwriting standards to foreign currency borrowers.                                         Strengthen framework for repurchase agreements and collateral seizure.                                               Liquidity Risk Contain maturity mismatch and maintain minimum level of liquid assets. Reduce fragmentation, develop benchmark securities and use primary dealers. Accounting and auditing standards ensuring quality of financial disclosure. Promote liquid market for foreign exchange transactions by fostering efficient and transparent trading and market conduct arrangements.                         Strengthen liquidity management skills and techniques. Make available collateralised line of credit to support primary dealers. Restrictions on exposure and concentration.           Establish limits against foreign currency mismatches.                               Settlement risk   —   Dematerialise securities, Centralise depository, Automated settlement on real time basis. Regulatory capital requirements, supervision of financial condition; early warning system. —                                                       Membership restrictions in trading system / settlement system.                                             Interest rate   —   Comply with prudential requirements for risk management of portfolios.   —   —   Risk -                                         Achieve an adequate degree of transparency in large positions,                                                       Trading data.                                       Exchange rate   —     —     —   Establish internal limits and monitoring mechanisms for foreign exchange exposure, including off-balance sheet items. Establish net open position limits. Set capital requirements against exchange rate risk. Develop instruments for hedging exchange rate risk. Risk                                                                                                                                                                                                                           Reference: Karacadag, C., V. Sundarajan and J. Elliott (2003), "Managing Risks in Financial Market Development", IMF Working Paper, No.116, IMF, Washington D.C.

Box II.5: Guidelines on Country Risk Management Country risk, which has an overarching effect on a bank’s international activities, is the risk that economic, social and political conditions in a foreign country might adversely affect a bank’s financial interests. Besides credit transactions, country risk includes investments in foreign subsidiaries, electronic banking agreements, electronic data processing servicing, and other outsourcing arrangements with foreign providers. It is, therefore, important that banks with significant international exposure have an effective country risk management process in place, commensurate with the volume and complexity of their international activities. The Core Principles for Effective Banking Supervision, released in 1997, had observed that "banking supervisors must be satisfied that banks have adequate policies and procedures for identifying, monitoring and controlling country risk and transfer risk in their international lending and investment activities and for maintaining reserves against such risks" (Principle XI). The assessment made by the Reserve Bank in 1999, regarding its compliance with the Core Principles revealed that country risk management (CRM) was one of the areas where there was an observed deficiency in India. Accordingly, after obtaining the views of banks on the draft guidelines, the Reserve Bank published the final guidelines on CRM in February 2003. These guidelines are applicable only in respect of countries where a bank has exposure of 2.0 per cent or more of its assets. The salient features of the guidelines may be grouped under the following seven heads: (a) policy and procedures, (b) scope, (c) ratings, (d) exposure limits, (e) monitoring, (f) provisioning, and (g) disclosures. • Policy and Procedures – The CRM policy should address the issues of identifying, measuring, monitoring and controlling country exposure risks. The policy should specify the responsibility and accountability at various levels for the CRM decisions. The banks would need to institute appropriate systems and procedures, laid down with the approval of the Board, for dealing with country risk problems. Finally, the CRM policy should stipulate rigorous application of the ‘Know Your Customer’ (KYC) principle in international activities. Scope – Banks would need to reckon both funded (e.g., cash and bank balances, deposit placements, investments, loans and advances) and non-funded (e.g., letters of credit, guarantees, performance bonds, bid bonds, warranties, committed lines of credit) exposures from their domestic as well as foreign branches while identifying, measuring, monitoring and controlling country risks. Banks would also need to account for indirect country risk (exposures to a domestic commercial borrower with a large economic dependence on a certain country), which may be reckoned at 50 per cent of the exposure. Exposures would need to be computed on a net basis (i.e., gross exposures less collaterals, guarantees, insurance, etc). Ratings – Banks need to institute appropriate systems to move over to internal assessment of country risks. Instead of relying solely on rating agencies or other external sources as the country risk monitoring tool, banks should also incorporate information from the relevant country managers of the foreign branches into their country risk assessments. The frequency of periodic reviews of country risk ratings should be at least once a year, with the provision for more frequent reviews in case of major events in the country where the bank exposure is high. Exposure Limits – The Boards of banks may set country exposure limits in relation to the bank’s regulatory capital (tier-I plus tier-II) with sub-limits, if necessary, for products, branches, maturity, etc. In case of foreign banks, the regulatory capital would be the sum of tier-I and tier-II capital held in their Indian books. Monitoring of Exposures – Banks should switch over to real-time monitoring of country exposures by March 31, 2004. In the interim period, banks should monitor their country exposures on a weekly basis. Country risk exposures would need to be reviewed at quarterly intervals. The review should include progress in establishing internal country rating systems, compliance with regulatory norms, internal limits, stress tests and the exit options available to the banks in respect of countries in the ‘high risk and above’ categories. Provisioning – Banks would need to make provisions, with effect from the year ending March 31, 2003, on the net funded country exposures on a graded scale ranging from 0.25 per cent (in case of insignificant risk) to 100 per cent (in case of restricted / off-credit risks). While banks may not make any provision for ‘home country’ exposures (i.e., exposure to India), they would need to include exposures of foreign branches of Indian banks to the host country. These provisions for country exposures would be allowed to be treated as tier-II capital, subject to a ceiling of 1.25 per cent of the risk-weighted assets. Disclosures – Banks would need to disclose as part of the ‘Notes on Accounts’ to the balance sheet as on March 31 every year, (a) the risk category-wise country exposures, and (b) the extent of aggregate provisions held thereagainst. It was decided that a review of the guidelines would be undertaken after one year, taking into account the experience of banks in implementing the guidelines. Reference: Reserve Bank of India (2003), Risk Management Systems in Banks – Guidelines on Country Risk Management, RBI: Mumbai.

Box II.6: Operational Risk and New Capital Accord The scope of operational risk is measured by the probability and impact of the unexpected losses stemming from the deficiency or failure of internal processes, people and systems, or from external events. A quantitative assessment requires such losses to be quantified as expected and assumes that probabilities and actual losses can be measured. Complete quantification is difficult in practice. The analysis of the probability and size of operational risks is also defeated by the lack of relevant data. One possible way out is to systematize operational risk and place them in the loss probability and size matrix (Table A). Table A: Size and Probability of Unexpected Losses Severity Probability   Low High Low C B High D A For operational risk policy, the following rules result from an analysis of the size and probability of losses. Business areas with a high likelihood and high level of operational risk (Cell A) to be avoided. Areas with a low level but high probability of losses (Cell B) are often not perceived as "risk areas", but merely "cost-intensive" or "low quality". In such cases, problems are frequently to be found in process and system design. Small-scale losses with a low degree of probability (Cell C) should be accepted if the costs of prevention exceed the amount of reduction in the losses. The significant operational losses are mostly located where the probability is low, but the severity is high (Cell D). For such cases, preventive measures such as governance, internal control and management incentives are most important. Given the fact that lack of adequate internal controls are behind many a major loss, the Basel Committee on Banking Supervision has in a recent study drafted several principles for executive management and boards of directors for monitoring by the banking supervisory authorities. The new Basel Accord provides a menu of approaches towards measurement of operational risk. Three such approaches have been proposed: basic indicator approach, standardised approach and the advanced measurement approach. Under the first approach, operational risk capital allocation is based on a single indicator (viz., Gross Income) as a proxy for operational risk exposure. Under the second approach, banks’ activities are divided into eight business lines (corporate finance, trading and sales, retail banking, commercial banking, payment and settlement, agency services, asset management, and retail brokerage). The capital charge for each business line is calculated by multiplying gross income by a factor (denoted as beta) assigned to that business line. Under the third approach, the regulatory capital requirement will equal the risk measure generated by the bank’s internal operational risk measurement using both qualitative and quantitative criteria. The qualitative criteria include independent operational risk management function, active involvement of board of directors / senior management in oversight of operational risk management process, regular reporting of operational risk exposure and loss experience and documentation of risk management system. Among the quantitative criteria are the demonstrated ability of the bank to capture potentially severe ‘tail’ loss events and sufficient ‘granularity’ in risk measurement systems to capture the major drivers of operational risk. In addition, the process of operational risk measurement would also need to include four key elements: tracking internal loss data, using relevant external data, employing scenario analysis to evaluate its exposure to high severity events and finally, capturing key business environment and internal control factors that can change the operational risk profile of the bank. These approaches are gradually increasing in the degree of sophistication and have built-in incentives to encourage banks to continuously improve their risk management and measurement capabilities and undertake more accurate assessment of regulatory capital. Since operational risk is one of the important elements of the New Capital Accord, banks would be required to stress upon their internal control and systems, particularly towards clearing of backlog in balancing of books to ward off clearing differences and inter-branch and nostro accounts reconciliation. The progress made by banks in India in reconciliation of clearing differences as well as inter branch and nostro accounts, which are prone to frauds, should be closely monitored by banks. It is also imperative that banks make concerted efforts to build up appropriate systems to reduce the outstandings as early as possible and also to avoid incidence of fresh outstandings. In order to prevent fraud and mitigate operational risk arising out of it, banks would be required to strengthen their internal systems and procedures and take specific steps, particularly in the following areas: (a) strictly follow the principles of corporate governance; (b) adhere to the KYC principle; (c) build robust systems and procedures to prevent fraud; and (d) strengthen internal audit and control systems and put in place accountability process for audit and inspection staff. References: Basel Committee on Banking Supervision (1998), Framework for Internal Control Systems in Banking Organisations, Basel. Basel Committee on Banking Supervision (2003), The New Basel Capital Accord (Third Consultative Document), Basel. Weigand, C. (2002), Operational Risk in the New Basel Capital Accord, presentation at Bank of Netherlands (available at www.dnb.nl).

2.72 Banks could use these guidance notes for upgrading their risk management systems. The design of risk management framework should be oriented towards the banks’ own requirements dictated by the size and complexity of business, risk philosophy, market perception and the expected level of capital. The systems, procedures and tools prescribed in the guidance notes for effective management of credit risk and market risk are merely indicative in nature. The risk management systems in banks should, however, be adaptable to changes in business size, the market dynamics and the introduction of innovative products by banks in future.

5. NPA Management by Banks

One-Time Settlement / Compromise Schemes

2.73 The guidelines for compromise settlements of chronic NPAs up to Rs.5 crore were issued in July 2000. On a review and in consultation with the Government of India, it was decided to give one more opportunity to the borrowers to come forward for settlement of their outstanding dues. The revised guidelines applicable to public sector banks will cover NPAs (below the prescribed ceiling) relating to all sectors including the small sector. The guidelines will not, however, cover cases of wilful default, fraud and malfeasance. The revised guidelines issued on January 29, 2003 for compromise settlement of dues relating to NPAs of public sector banks in all sectors are as follows:

• Guidelines are applicable for compromise settlement of chronic NPAs up to Rs. 10 crore.
• The guidelines will cover all NPAs in all sectors irrespective of the nature of business, which have become doubtful or loss assets as on March 31, 2000 with outstanding balance of Rs. 10 crore and below on the cut off date.
• The guidelines will also cover NPAs classified as sub-standard assets as on March 31, 2000, which have subsequently become doubtful or loss assets.
• The guidelines will be applicable to cases in which the banks have initiated action under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 and also cases pending before Courts / Debt Recovery Tribunals (DRTs) / Board for Industrial and Financial Reconstruction (BIFR), subject to consent decree being obtained from the Courts / DRTs / BIFR.

• The last date for receipt of applications from borrowers under the scheme was September 30, 2003 and their processing should be completed by December 31, 2003.

2.74 Guidelines for special One-Time Settlement Scheme for loans up to Rs.50,000 to small and marginal farmers by PSBs which were issued in March 2002 were to be operational up to December 31, 2002. The Government and the Reserve Bank had received requests from banks for extending the time limit of the operation of the guidelines. In view of the above and keeping in view the drought / flood situation in different parts of the country, it was decided, in consultation with the Government of India, to extend the operation of the guidelines, for a further period of 3 months, i.e., up to March 31, 2003.

Lok Adalats

2.75 The Reserve Bank has issued guidelines to commercial banks and FIs to enable them to make increasing use of Lok Adalats. They have been advised to participate in the Lok Adalats convened by various DRTs / Debt Recovery Appellate Tribunals (DRATs) for resolving cases involving Rs. 10 lakh and above to reduce the stock of NPAs. As on June 30, 2003, the number of cases filed by banks in Lok Adalats stood at 2,72,793 involving an amount of Rs.1,193.3 crore and amount recovered in 87,907 cases was Rs. 190.5 crore.