INDIA’S FINANCIAL SECTOR AN ASSESSMENT

Volume IV

INDIA’S FINANCIAL SECTOR AN ASSESSMENT

Volume IV
Advisory Panel on Financial Regulation and Supervision

Committee on Financial Sector Assessment March 2009

© Committee on Financial Sector Assessment, 2009

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Approach to Assessment

1. Approach To Assessment

The Government of India in consultation with the Reserve Bank constituted the Committee on Financial Sector Assessment (CFSA) in September 2006, with a mandate to undertake a comprehensive assessment of the Indian financial sector focusing upon stability and development. The CFSA was chaired by Dr. Rakesh Mohan, Deputy Governor, Reserve Bank of India. The Co-Chairmen were Shri. Ashok Jha, Dr. D. Subbarao and Shri. Ashok Chawla, Secretary Economic Affairs, Government of India. The Committee also had officials from the Government of India as its members.

Taking into account the legal, regulatory and supervisory architecture in India, it was felt that there was a need for involving and associating closely all the major regulatory institutions, viz., The Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI) and Insurance Regulatory and Development Authority (IRDA), in addition to representatives from the Government for this exercise. In order to leverage the available expertise to the maximum permissible extent, it was also deemed fit to involve, besides the regulatory authorities other agencies as relevant to the work.

To assist the Committee in the process of assessment, the CFSA constituted four Advisory Panels for Financial Stability Assessment and Stress Testing, Financial Regulation and Supervision, Institutions and Market Structure and Transparency  Standards respectively in August 2007. While the Panel on Financial Stability Assessment and Stress Testing conducted macro-prudential surveillance to assess the soundness and stability and developmental aspects of financial system, the other three Panels identified and evaluated the implementation of relevant standards and codes in different areas. All Panels have dealt with measures for strengthening the financial system from a medium-term perspective. The Panels were assisted by Technical Groups comprising mainly of officials from relevant organisations to provide technical inputs and data support, as appropriate to the respective Advisory Panels. A Secretariat was constituted within the Monetary Policy Department (MPD) in the Reserve Bank to provide logistical and organisational support to the Advisory Panels and Technical Groups.

Advisory Panel on Financial Regulation and Supervision

As part of the assessment of standards and codes, the terms of reference of the Advisory Panel on Financial Regulation and Supervision were to identify and consider the relevant standards and codes as currently prescribed and applicable for financial regulation and supervision pertaining to the banking sector, securities markets and insurance and evaluate their implementation in the Indian context; identify the gaps in adherence to these standards and codes and the reasons therefor; and suggest possible roadmaps addressing, inter alia, the developmental issues relating to these standards and codes, in the medium-term perspective. The Advisory Panel chaired by Shri M S Verma comprised of non-official experts as members and officials representing Government and other agencies as special invitees – Annex A.

Technical Group on Financial Regulation and Supervision

A Technical Group comprising of officials drawn from Government and other agencies who are directly associated with / handling respective areas of work assisted the Advisory Panel in preparing preliminary assessments and background material which served as inputs to the Advisory Panels work (Please see Annex B for the composition of the Technical Group and terms of reference). Apart from the officials indicated in the Annex B the Panel also benefited from the inputs of the officials indicated in Annex C. The IRDA formed its own Technical Group for assessment of IAIS Core Principles for Insurance Regulation – Annex D.

Approach and Methodology

The Technical Group identified the Basel Core Principles (BCPs) (2006) as the relevant standard applicable to the assessment of the banking sector. In addition to the adherence to the BCPs regarding supervision of commercial banks, the Group also assessed the adherence of the core principles in other relevant and closely related areas such as the urban co-operative banking sector, rural credit institutions and non-banking financial companies including housing finance companies. The template developed by IMF/ World Bank for conducting FSAP was utilised for the assessment.

Likewise, the IOSCO Principles (2003) were identified as the relevant international standard applicable to assess the regulation and supervision in respect of securities market. The assessment of implementation of IOSCO principles encompassed besides corporate bond, equities and government securities markets, money and foreign exchange markets to the extent found relevant and applicable. The IOSCO templates in conjunction with the format developed by IMF/World Bank was utilised to make the assessment.

The adherence to Core Principles of the International Association of Insurance Supervisors (IAIS) (2003) was identified as the relevant international standard for the insurance sector. The IMF/World Bank FSAP templates was utilised for the assessment.

The preliminary assessments made by the Technical Groups were considered by the Advisory Panel with closer involvement of three sub-panels (Annex E) in the areas of Banking Supervision (Basel Core Principles), Securities Market Regulation (IOSCO Principles) and Insurance Regulation (IAIS Core Principles).

The Advisory Panel had a total of five meetings to consider the assessments and recommendations and to finalise the report. In addition, the sub-panel on Basel Core Principles (BCPs) had three meetings, sub-Panel on IOSCO principles had two meetings and sub-Panel on IAIS Principles had three meetings.

Peer review

At the request of the CFSA, five international experts on areas relating to banking supervision, supervision of securities markets and insurance sector supervision peer reviewed the draft reports on respective assessments and recommendations – Annex F.

The Advisory Panel considered in depth the comments made by the peer reviewers and appropriately modified the report after incorporating the comments /suggestions. The Panel had also the option to differ with peer reviewers’ comments, if they considered appropriate particularly in the Indian context. In the interest of transparency, the comments of the peer reviewers and the stance taken by the Panel are provided appropriately in respective parts of this report.

Scheme of the Report

The report is divided into six major Chapters. Following this, Chapter 2 considers some overarching issues pertinent to all regulators. Chapter 3 covers assessment of the Basel Core Principles (BCPs). The assessment covers primarily commercial banks, but as relevant and applicable, also covers Urban Co­operative Banks (UCBs), State Co-operative Banks (StCBs) and District Central Co-operative Banks (DCCBs), Regional Rural Banks (RRBs), Non-banking Finance Companies (NBFCs) and Housing Finance Companies HFCs).

Chapter 4 covers the assessment of IOSCO principles covering primarily equities and corporate bond market and government securities market, but as relevant and applicable also covers money market and foreign exchange market.

Chapter 5 covers the assessment of IAIS Core principles covering essentially insurance companies which are registered with the supervisor.

Chapter 6 concludes with a summary of recommendations pertaining to all issues and assessments.

Annex A

RESERVE BANK OF INDIA
CENTRAL OFFICE,
SHAHID BHAGAT SINGH ROAD,
MUMBAI – 400 001, INDIA

MEMORANDUM

Constitution of Advisory Panel on Financial Regulation and Supervision

A Committee on Financial Sector Assessment (CFSA) has been constituted by the Government of India (GoI) in consultation with the Reserve Bank with the objective of undertaking a self-assessment of financial sector stability and development. One of the analytical components of Financial Sector Assessment would encompass a comprehensive assessment of the status and implementation of various international financial standards and codes.

2. In this connection the CFSA has decided to constitute an Advisory Panel on Financial Regulation and Supervision comprising the following:

3. In addition, the Advisory Panel can utilise the expertise of the following ex-officio Special Invitees:

4. The Advisory Panel will have the following terms of reference:

(i) to identify and consider the relevant standards and codes as currently prescribed and applicable for financial regulation and supervision pertaining to the banking sector, securities markets and insurance and evaluate their implementation in the Indian context;

(ii) to identify the gaps in adherence to the respective standards and codes and the reasons therefor; and

(iii) to suggest possible roadmaps addressing, inter alia, the developmental issues relating to respective standards and codes, in a medium-term perspective.

5. The Advisory Panel would have the option of co-opting as Special Invitees any other experts as they deem fit.

6. The secretarial assistance to the Advisory Panel will be provided by the Reserve Bank. The Technical Groups on Financial Regulation and Supervision constituted by the Reserve Bank and the Insurance Regulatory and Development Authority (IRDA) at the instance of the Committee have already progressed with the technical work with regard to above terms of reference. The technical notes and background material prepared by these groups would inter alia form the basis for discussion by the Panel and in drafting of the Report.

7.The Advisory Panel will prepare a detailed Report covering the above aspects and the Government of India (GoI) The Reserve Bank will have the discretion of making the Report public, after a peer review, as they may deem fit.

8. The Advisory Panel is expected to submit its Report in about three months from the date of its first meeting.

(Rakesh Mohan)

Mumbai
August 10, 2007

Deputy Governor and Chairman of the Committee on Financial Sector Assessment

Annex B

RESERVE BANK OF INDIA
CENTRAL OFFICE,
SHAHID BHAGAT SINGH ROAD,
MUMBAI – 400 001, INDIA

Constitution of Technical Group on Financial Regulation & Supervision

The Committee on Financial Sector Assessment (CFSA) will undertake a self-assessment of financial sector stability and development. One of the analytical components of Financial Sector Assessment would encompass a comprehensive assessment of the status and implementation of various international financial standards and codes. CFSA has decided to constitute a Technical Group on Financial Regulation & Supervision comprising the following:

2. The Group will have the following terms of reference:

(i) to identify the relevant standards and codes as currently prescribed and applicable for financial regulation & supervision pertaining to the banking sector, securities market, insurance and market integrity; and

(ii) to compile relevant data and information on follow-up of earlier assessments and recommendations made by the earlier FSAP and also internally by the Standing Committee on International Financial Standards and Codes on the relevant standards; and

(iii) to contribute to technical work in the relevant area and provide a fair and independent assessment on the matters under the consideration of the Technical Group; and

(iv) to identify the gaps in adherence to the respective standards and codes and the reasons therefor; and

(v) to suggest possible roadmaps addressing, inter-alia, the developmental issues, in the medium term perspective; and

(vi) to provide such inputs for discussion to the relevant Advisory Groups constituted by the Reserve Bank and other regulatory agencies.

3. The Group would function under the overall guidance of Shri V. K. Sharma, Executive Director, Reserve Bank of India. Shri Anand Sinha, Executive Director, Reserve Bank of India will be a permanent invitee.

4. The Group will also be guided by decisions taken in the Advisory Panel for Financial Regulation & Supervision.

5. A list of Special Invitees who could act as resource persons to the Group and whose expertise can be called upon by the Group while preparing inputs for the Advisory Panels is provided in the Annex C. The Group may co-opt as special invitees, one or more of the identified officials, or any other officials from RBI, Government or other agencies as they deem appropriate.

6. The Group is expected to complete its task in the minimum possible time which, in any case, would not go beyond three months from the date of its constitution.

Mumbai
March 1, 2007

(Rakesh Mohan)
Chairman

Annex C

List of officials who assisted the Advisory Panel

The Panel has also benefited considerably from the inputs provided by following officials from different agencies.

Further, the Panel also acknowledges the contributions made by the following officials in preparation of the draft reports.

Annex D

List of Members who were part of Technical Group for Assessment of
IAIS Core Principles

Annex E

Details of Sub-Panels formed by the Advisory Panel on Financial Regulation and Supervision

Overarching Issues

1. Introduction

The Advisory Panel on Financial Regulation and Supervision was assigned the following tasks:

(i) Assessment of Basel Core Principles
(ii) Assessment of IOSCO Principles
(iii) Assessment of IAIS Core Principles

The assessment of the Basel Core Principles covers commercial banks, urban co-operative banks, State Co-operative Banks, District Central Co-operative Banks, Non-Banking Finance Companies and Housing Finance Companies. The assessment of IOSCO principles covers the equities/corporate bond market, the Government Securities market, the money market and the foreign exchange market and their related derivatives. The assessment of IAIS Core Principles covers the insurance sector. The assessments in respect of all the three principles have been made not merely on the issuance of rules/guidelines by the regulatory authorities, but also taking into account the ground realities as regards the effective implementation of these rules/ guidelines by the regulated entities. It reveals that the regulatory and supervisory structure of the Indian financial system is both elaborate and adequate. Over the years the regulatory and supervisory structure of banks, insurance companies and markets has strengthened significantly and has acted as an effective mitigating factor against systemic vulnerability. The gradual and calibrated approach of the authorities in adopting a more liberal financial system has paid dividends and India has not been subject to any major financial stress for nearly 20 years. While assessing the regulatory and supervisory environment against accepted international benchmarks, the Panel feels that there is still some way to go in terms of the adoption of international best practices by India. Accordingly, the Panel has identified the major gaps in regulation and supervision and recommended the way forward from a medium-term perspective by providing specific recommendations. Certain overarching issues across sectors/markets have also arisen during the course of the assessment. These are delineated in Section 2.

2. Overarching Issues

2.1 Applicability of Principles-Based Regulation in the Indian Context

The Panel discussed at length as a developmental issue the choice between principles-based and rules-based regulation in the Indian context (Box 2.1). India follows a model of regulation which is primarily rule-based. The High Powered Expert Committee on making Mumbai an international financial centre (set up by the Ministry of Finance) had argued strongly in favour of a shift to principles-based regulation to bring about greater flexibility in the regulatory environment, and make it more adaptable to global financial demands. The environment, the Committee argued, would be innovation-friendly and therefore appropriate and necessary for the transition of Mumbai to a IFC.

Over a period of time, India has built up a large repository of subordinate laws through a codification of detailed rules and regulations by specialised regulators. These give in detail the permissible features of financial products and services as also the functioning of financial markets. This helps to avoid legal ambiguity through precise codification. For instance, in the banking sector, there are varied sets of entities ranging from commercial banks, urban co­operative banks and rural financial institutions. The commercial banks are the most advanced and are in the Basel I mode and have started migrating to the Basel II mode in a phased manner from March 31, 2008. Urban Co-operative Banks are only partly in the Basel I mode and it may take some time before they migrate to the Basel II mode. Rural Co-operatives at present have no stipulation of capital adequacy. A roadmap has been drawn for their transition to capital adequacy and it will take some time for them to migrate to the Basel mode. Thus, these entities though in the same regulatory segment, are in various stages of development. An effort to regulate them by principles-based regulation will be ineffective and may not yield the desired results.

As regards financial markets, the Indian equities market is one of the most advanced in the world. The foreign exchange market has also acquired considerable depth and vibrancy. In the debt market, while the government securities market has expanded, it needs to acquire further depth. However, the corporate bond market is yet to take off in any significant way. After the abolition of the office of the Control of Capital Issues, SEBI devised a new regime which has moved away from the old merit-based regulation to disclosure-based and market-based regulation. Some principles such as treating the customer fairly, avoidance of conflicts of interest, maintenance of integrity, etc., have been prescribed as the code of conduct for market intermediaries. There are also specific regulations where investors have been given enforceable rights. Thus, a hybrid approach is prevalent as far as regulation of intermediaries is concerned. As regards product regulations, SEBI requires the disclosure of risk factors, suitability to investors, avoidance of systemic risk and mis-selling. In the securities market too, conditions are far from ripe to move to principles-based regulation. Other markets too need to acquire further depth and maturity before a transition to principles-based regulation can be successfully attempted.

The insurance sector is in a nascent stage of development, and given the fact that it was liberalised only in 1999/2000, it may not be appropriate to move to a principles-based supervisory approach right now. The setting up of a principles-based approach with activity-based supervision will have to wait till the industry develops adequate data bases and skill sets. Rule-based and institution-based super vision has to continue till public confidence in the sector improves significantly and regulator y comfort reaches a satisfactory level.

The implementation of principles-based regulation requires a high degree of market integrity and maturity. The existence of strong and effective Self-Regulatory Organisations (SROs) is an important pre­requisite. In this context, however, concerns over potential conflicts of interest need to be addressed. The Panel feels that the bodies, if designated to be SROs, might either have to suspend their functions as trade/industry associations (e.g., Investment Dealers’ Association, Canada) or change their governance structure to ensure a separation of operations as trade organisations and SROs (e.g., Japan Securities Dealers Association, Japan). Properly functioning SROs could act as unbiased interpreters and monitors ensuring due adherence to the prescribed principles of regulation. Further, regulatory principles need to evolve with time and changes in the background of regulation. The SRO’s role lies also in ensuring that in the course of such contextualisation and evolution, the spirit behind the principle remains protected. It, therefore, requires to be examined in detail whether the set of pre-conditions to be met for successful implementation of principles-based regulation exist in the Indian context.

There is a strong and inseparable link between human resource challenges and effective implementation of principles-based regulation. Also, principles-based regulation requires the staff of regulatory agencies to have both a holistic understanding of financial institutions and financial markets and a technical understanding of modern risk management models. Such individuals are in short supply, and there is intense competition from the private sector for them. Given the state of our development, markets, expertise and skills, the level of compliance, etc., at the ground level, the Panel, while appreciating the advantages of principle-based regulations, still had reservations about its early introduction in the current Indian environment.

There could, however, be a mix of approaches in adopting an appropriate regulatory model for India, with elements of both principles-based and rules-based regulation. A regulatory regime could be adopted in which a principles-based approach is applied initially only for the development of new and innovative products, thus creating a conducive atmosphere for product development without curtailing innovation, and continue otherwise with the rules-based approach. An alternative approach could be to apply a principles-based approach only in advanced market segments in the country. But in view of the variety of segments and the differing levels of their development and regulation, defining a threshold level for this purpose would be a formidable task at this stage. It needs to be kept in mind that adopting either approach could result in a fair degree of ambiguity in the overall regulatory environment at least in the initial stages of their introduction.

The Panel therefore, concluded that before any large scale migration to an alternative regulatory regime is effected, the relevant issues would need to be examined in detail. Significant amendments to existing legislations governing the regulator y framework of the financial system, would also be needed.

Box 2.1: Principles-based regulation v/s. Rules-based regulation

There are two forms of regulation prevalent across countries: rules-based regulation and principles-based regulation. Countries following the principles based regulation are UK, Ireland and Australia, while countries like USA, India and continental Europe follow the rules-based regulation.

Rules-based regulation has two strengths: Market players are aware of the certainty of the rules and able to abide by these rules governing all aspects of the business. The financial regulators and supervisors are also able to operate with certainty, but in a non-discretionary manner. The proponents of the principles-based regulation point to some inherent weaknesses in the rules-based approach:

• The focus is on the letter of the law and not on the spirit.

• It bridles innovation inasmuch as every new idea on products, services, markets or even new ways of doing business requires regulatory approval/clearance and often a modification of rules.

• Vested interest groups seek to influence the evolution of rules to favour themselves.

The alternative to rules-based regulation is principles-based regulation which was first introduced in the UK in 1997. The new approach is gradually finding favour among International Financial Centres (IFCs) like Singapore. This method places greater emphasis on principles and is outcomes-focused, high-level rules as a means to achieve the regulatory goals. The proponents of principles-based regulation favour it for the following reasons:

• Detailed rules have become an increasing burden on regulators and the country’s resources

• Regulation that focuses on outcomes rather than prescription is more likely to support development and innovation.

• A large volume of detailed, prescriptive and highly complex rules diverts attention towards adhering to the letter rather than to the spirit of guidelines.

Under principles-based regulation the top management of a financial firm is held accountable for ensuring that the business plan of the firm and all its activities are consistent with the principles defined by the regulator. Instead of supervision in terms of checklist compliance, supervisors are required to understand the entire gamut of financial firms’ activities, financial and governance indicators, its corporate culture, as well as the strength and depth of its compliance procedures. It has also been argued that while rules-based regulations are eminently suitable for entities dominated by retail investors, principles-based regulation is more suited in environments characterised by a preponderance of institutional investors.

According to the US Securities Exchange Commission (SEC), the move to principles-based regulation is driven by commercial competitiveness among financial centres in the world today. These centres are doing so to gain a competitive edge over others overlooking the inherent dangers.

As compared to rules-based regulation which is specific and thus leaves limited discretion with the regulated in matters of adherence to the rules, principles-based regulation provides far greater discretion to the regulated which can and often does result in the principles being compromised due to the regulated entity’s inadequate appreciation of the principles or cutting corners under stress.

Reference: (i) Report of the High Powered Committee on making Mumbai an International Financial Centre, Ministry of Finance, Government of India (ii) Speech by SEC Commissioner: Principles vs. Rules by Commissioner Roel C Campos.

2.2 Independence of Regulatory and Supervisory Authority

SEBI is a statutory body established under the SEBI Act, 1992. Its powers and functions are specified in the SEBI Act. It also exercises powers under SC (R) Act, Depositories Act and certain provisions of Companies Act. It is empowered to frame regulations without the approval of the Central Government and is able to operate and exercise its powers given under various Acts referred to above without external political and commercial interference. Section 6 of the SEBI Act, 1992 states that a member can be removed in circumstances referred to therein after being afforded a reasonable opportunity of being heard. Only in cases of grave emergencies or where SEBI is unable to discharge its functions or in public interest can the Board of SEBI be superseded by the Central Government in accordance with the procedures provided in Section 17 of the SEBI Act. However Section 5(2) gives the Central Government the right to terminate the services of the Chairman or Member at any time by giving a notice of three months. This appears to be in apparent conflict with the tenor of the other sections in the SEBI Act and could have implications for the independence of SEBI. The Panel feels that Section 5(2) can be removed from the SEBI Act.

The Insurance Regulatory Development Authority (IRDA) is an independent agency which reports to Parliament through the ministry of finance. The Chairperson of IRDA is appointed by the Cabinet Committee on Appointments headed by the Prime Minister. The Central Government reserves the right to remove any member including the Chairman, under specified conditions. The chairperson, members, officers and staff of the IRDA are provided protection through their status as “public servants” and are protected from legal action for acts done in good faith under the Act, Rules and Regulations. While, as per the precedent and practice, the Government of India has always recognised and fostered the independence to the IRDA, there are no doubt legacy issues arising from the provisions of the Insurance Act which vests several powers with the Government of India in the context of the insurance sector. However, these would largely be addressed in the proposed amendment Bill which is now under consideration of the government.

Recognising regulatory independence as one of the key objectives, the relevant provisions in the RBI Act were examined by the Panel in detail. The Reserve Bank’s governance structure is laid down clearly and it was felt that there is adequate openness and transparency in its decision making. It also enjoys the required autonomy in setting rules and regulations for the sectors under its supervision. Section 35A of the Banking Regulation Act, 1949, empowers the Reserve Bank to issue directions to banks. Further, as per Section 54 of the Banking Regulation Act, 1949, bank supervisors enjoy legal protection when executing their jobs. However, it was observed that though Section 8 of the RBI Act provides for the composition of the Central Board and terms of office of its directors, it does not provide any procedure for the appointment of the Governor or the bank’s governing board. The terms of office of the Governor are contractual (as specified in the appointment order). While the directors nominated to the Board can be removed only on incurring disqualifications mentioned in the RBI Act (Section 10), for the Governor and Deputy Governors there are no explicit provisions detailing the situations in which they can be removed. In fact, Section 11 of the Act provides that the Central Government may remove the Governor or Deputy Governor from office (without specifying any reasons for the same). Further, according to Section 30 of the RBI Act, the government has the power to supersede the Central Board of the Reserve Bank in specific circumstances.

The Reserve Bank’s tasks and goals are multifarious in nature. In addition to being the regulator and supervisor of commercial banks and various other categories of financial institutions, it is the monetary authority of the country. Its tasks encompass, inter alia, sovereign debt management, foreign exchange reserve management and issuance of currency. These role requirements can be conflicting in some situations. The case for complete institutional independence of the Reserve Bank as a regulator needs to be viewed in this overall context. The convention that has developed in this regard over time also merits attention. While

Box 2.2: Regulatory Independence

The need for regulatory and supervisory independence has been in sharp focus in recent times. An analysis of the causes of the financial sector crises of the 1990s, indicates that the lack of independence of supervisory authorities from political influence has been one of the contributing factors to the deepening of the crisis. A second factor to have highlighted the importance of regulatory and supervisory independence is the discussion on the most appropriate regulatory and supervisory structure, including the organisational structure of banking supervision within or outside the central bank.

Some countries have shown a tendency to move to a unified financial sector supervision by removing the banking supervision function from the central bank. Quintyn and Taylor argue that while the separation of the monetary policy function from the regulatory and supervisory functions could have implications for the independence of the regulator and supervisor as removing supervision from the central bank could create a less independent function than has previously existed. The appropriate degree of independence for the new, unified ‘super regulator’ is a matter still being debated. At the same time, the creation of a supervisory superpower raises fears regarding the concentration of power, thereby reopening the unsettled debate about well-established accountability. It can be argued that bank regulatory and supervisory independence is for financial stability what central bank independence is for monetary stability and that independence of the two agencies in charge of monetary and financial stability would have a mutual reinforcing effect.

According to Quintyn and Taylor, there are four dimensions of independence:

(i)  Regulatory independence, which refers to the ability of the agency to have an appropriate degree of autonomy in setting rules and regulations for the sectors under its supervision within the confines of law.

(ii) Supervisory independence can be increased through provision of legal protection to supervisors, introduction of rules-based sanctions and interventions, appropriate salary levels and clarity of banking law regarding layers of decisions and time allowed for appeal by institutions sanctioned by supervisors. The supervisor should have autonomy related to licensing and exit procedures.

(iii) The critical elements in Institutional independence are terms of appointment and dismissal of senior supervisory personnel, the agency’s governance structure and its openness and transparency in decision-making

(iv) Budgetary independence refers to the role of the executive/legislature in relation to the funding requirements of the agency.

The appropriate degree of independence would, however, be country specific depending on the existing institutional framework, including specific co-ordination arrangements to ensure information exchange and policy co-ordination among all autonomous institutions, be it monetary management or regulation and supervision. The recent ‘sub-prime’ crises in some instances have brought to for the fore the possibility of role conflict between the monetary and supervisory authorities and lack of effective communication between the two.

Reference: IMF Working Paper No. WP/02/46 – Regulatory and Supervisory independence and financial stability – Marc Quintyn and Michael W. Taylor

the Central Government, de jure, is empowered to remove the Governor without assigning any reason, such power has never been exercised and, over time, the Reserve Bank has come to be perceived as one of the most independent and autonomous bodies in the Indian financial sector. With such a convention already in place, and the checks and balances of a strong and vibrant democratic system, the government would run a huge reputational risk if ever it decides to remove the Governor/Deputy Governor without sufficient cause. Considering the Reserve Bank’s success as a regulator amidst its diverse activities, and the fact that by convention the Reserve Bank’s independence is fairly well established, the Panel feels that at this stage there is no real requirement to amend the law to include specific clauses detailing circumstances in which the Reserve Bank Governor/Deputy Governor could be removed. Such changes are not likely to add or make any material difference to the autonomy the Reserve Bank already enjoys as a regulator.

2.3 Financial Independence

The Reserve Bank was established under the RBI Act, 1934 on April 1, 1935 as a private shareholders’ bank. Since its nationalisation in 1949, it is fully owned by the Government of India. The Preamble to the RBI Act lists basic objectives as: “to regulate the issue of bank notes and keeping of reserves with a view to securing monetary stability in India, and generally, to operate the currency and credit system of the country to its advantage”. There is no inherent limitation on the part of the Reserve Bank in obtaining and deploying the resources required for carrying out its supervisory mandate. The Reserve Bank is financed by its own budget and has not been required to receive any financial support from the Central Government. With a view to maintaining the strength of the Reserve Bank finances, the transfer of the balance of profits, after necessary provisions, to the Central Government has been rationalised as part of the reform process in 1997. The present arrangement is governed by the objective of reaching a stipulated level of reserves in the Reserve Bank’s balance sheet over a period – though the time-frame to reach the level is extended by mutual consent to accommodate immediate fiscal compulsions. The cost of sterilisation in the form of interest costs under the Market Stabilisation Scheme is borne by the Central Government. Sterilisation through the Cash Reserve Ratio (CRR) on an unremunerated basis also helps to minimise the cost of such interventions. Under these circumstances, the Reserve Bank may be considered as enjoying a very high degree of financial independence.

SEBI is empowered to levy fees and other charges for performance of its functions. It is not dependent on the government or any authority for its funds. During its initial days, the government had provided it interest-free loans which are being repaid by SEBI from its fund. The provision for fees and penalties under the SEBI Act are considered adequate at present to meet the resource needs of the SEBI.

The IRDA is an autonomous body formed by the Insurance Regulatory Development Authority Act, 1999. The Insurance Act, 1938 and the regulations framed thereunder lay down the regulatory framework for supervision of entities operating in the sector. With respect to financial independence, an issue has been raised by the government on the transfer of IRDA’s funds to the exchequer (Public Account of India). The instructions were issued invoking Article 266 (2) of the Constitution of India. However, the IRDA has taken the stand that it is not carrying on sovereign functions on behalf of the government. As such, the provisions of the said Article are not applicable to it. While the request has not yet been acceded to and is under examination, any action in this regard would be detrimental to and raise serious concerns relating to the supervisor’s stature as an autonomous regulator.

Regulators provide a public good at a cost. The Panel underscores the need to maintain their financial independence.

2.4 Capacity Building and Skill Enhancement

Migration to Basel II norms presupposes familiarity and expertise in quantitative techniques and statistical methods. There is a need for capacity building both from the perspective of the regulated and the regulator. Recruitment and development of a specialised cadre to cater to the impending requirements of Basel II in banks is a must. Lateral

Box 2.3: Implementation of Basel II in India

In order to strengthen the capital base of banks, the Reserve Bank decided in April 1992 to introduce a risk based capital adequacy system for commercial banks along the lines of the Basel Committee on Banking Supervision (BCBS) framework on capital adequacy (1988). This takes into account the elements of credit risk in various types of assets in the balance sheet as well as in the off-balance sheet business. Non-banking finance companies and housing finance companies introduced the risk-based capital adequacy norms from January 1998 and March 2001 respectively. Risk-based capital adequacy norms were extended in a phased manner to urban co-operative banks from March 31, 2002. Capital adequacy norms in line with Basel I prescriptions are yet to be introduced for rural financial institutions, viz., regional rural banks, state co-operative banks and district central co-operative banks.

Further, the Reserve Bank issued guidelines to banks in June 2004 on the maintenance of capital charges for market risks on the lines of the ‘Amendment to the Capital Accord to incorporate market risks’ issued by the BCBS in 1996. Banks were required to apply the Standardised Duration Approach (SDA) for computing capital requirements for market risks.

In June 2006, the BCBS released the “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” popularly called the Basel II. The framework is expected to promote the adoption of stronger risk management practices in commercial banks. Basel II is based on three mutually reinforcing pillars – minimum capital requirements, supervisory review and market discipline. Under Pillar I, the framework offers three distinct options for computing capital requirements for credit risk and operational risk respectively.

These approaches are based on increasing risk sensitivity and allow banks/supervisors to select an approach which is most appropriate to the stage of development of the bank’s operations. The approaches available for credit risk are the Standardised Approach (SA), Foundation Internal Rating-Based Approach and Advanced Internal Rating-Based Approach. The approaches available for computing capital charges for operational risk are the Basic Indicator Approach (BIA), Standardised Approach and Advanced Measurement Approach.

In order to have consistency and harmony with international standards, the Reserve Bank decided that all commercial banks in India (excluding local area banks and regional rural banks) shall adopt SA for credit risk and BIA for operational risk. Foreign banks operating in India and Indian banks having an operational presence outside India should adopt SA for credit risk and BIA for operational risk for computing their capital requirements under 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 these approaches under the Revised Framework in alignment with them not later than March 31, 2009.

After adequate skills are developed, both in banks and at supervisory levels, some banks may be allowed to migrate to the Internal Rating Based Approach for credit risk and the Standardised Approach or the Advanced Measurement Approach for operational risk for computing regulatory capital requirements after obtaining specific approval from the Reserve Bank.

Reference: RBI circular on implementation of Basel II in banks

recruitment of specialists with requisite skill sets could also be considered by banks and the Reserve Bank. The incentive structure and compensation package should be in alignment with market trends. There is also a need to examine the HR policies including transfer policies in the banking sector (particularly of public sector banks).

This aspect is equally true for SEBI. Though the compensation package offered by SEBI is comparable to other regulators in the financial market, its attrition rate is very high as the remuneration or compensation package of the financial services industry is much higher. Further, it is noticed that SEBI staff quits after gaining some experience mostly to join regulated entities subject only to the requirement of prior permission or a cooling off period. With liberalisation and opening up, a steady outflow of its staff to regulated entities is bound to create an adverse balance of skills on the part of the regulator. This will weaken the efficiency and credibility of regulation. Capacity building and skill enhancement are also issues, more so, with various innovations and new developments taking place in the securities market.

As regards the insurance sector, while IRDA has been taking a number of steps to increase and empower its manpower to discharge its functions, given the fact that the insurance sector is fast expanding, a number of new issues are required to be addressed. As such, there is a continuing need for enhancing the skill sets. With the insurance regulator thinking in terms of risk-based capital requirements and aspects relating to risk management for insurance companies, the agency needs to take steps to strengthen its machinery in terms of adequate skills for its officials which would require capacity building. Similarly, there could be issues regarding the retention of skilled staff. While regulators may be unable to match their remuneration structure with industry levels, the incentive structure for staff including top management should be built up to retain the best talents and sustain the morale.

The Panel regards capacity building of regulators as a serious issue and recommends a market related incentive structure to attract and retain talent and added attention to training and development. It recognises that every effort has to be made to match industry level remuneration to attract and retain the best available talent for regulation. While in the Indian context it would never be easy for the regulator to match the ever-increasing remuneration levels of industry, it will have to be ensured that the gap between the two remains manageable and the efficacy of the system is not undermined.

2.5  Co-operation between Regulators

In India, banks are regulated and supervised by the Reserve Bank/NABARD, non banking finance companies (NBFCs) are regulated and supervised by the Reserve Bank and the Ministry of Corporate Affairs and housing finance companies (HFCs) are regulated and supervised by the National Housing Bank. The equities/corporate bond market / exchange traded derivatives and mutual fund industry is regulated by the Securities Exchange Board of India. The government securities market, money market and foreign exchange market are mainly regulated by the Reserve Bank. The insurance sector is regulated by IRDA.

Given the multiplicity of regulators and overlaps in their functioning, there is a need for effective inter-regulatory co-operation. This need is further reinforced by the following:

• Government securities and related derivatives and money market instruments are listed on stock exchanges. To that extent, some aspects of the government securities market/ money market regulation are shared by the Securities Exchange Board of India (SEBI). SEBI is vested with the task of investor protection, regulating various market intermediaries and the securities market. Thus, any violation committed by market intermediaries or any violation which is not in the interest of investors is looked into by SEBI. Any other violations in respect of the government securities market or the money market come under the purview of the Reserve Bank. Likewise, though banks are regulated and supervised by the Reserve Bank/NABARD, there are instances wherein they need to interact with the regulator of markets, because of their exposures in the equities market or stakes in subsidiaries which deal in equities or insurance. This underscores the need for inter-regulatory co-operation given the fact that regulators are different for these areas.

• A significant portion of the funding of non-deposit taking NBFCs and investment companies, in particular, is through debt mutual funds. These NBFCs are then dependent on retail funds in the nature of ‘quasi deposits’. Though there are exposure limits for funds in respect of individual companies (to the extent that a mutual fund cannot invest more than 15 per cent of its NAV in debt instruments issued by a single issuer) there is no restriction of their total quantum of exposure to the NBFC sector as a whole. Also, NBFCs do not have any regulatory limits on their exposure to sensitive sectors like real estate or capital markets. There exists, therefore, a significant risk of contagion as retail funds are exposed to these sectors, which, in the event of an asset price correction, may crystallise into significant losses. This contagion may get magnified during a liquidity crisis as NBFCs and debt mutual funds would be more susceptible to liquidity mismatches compared to banks. Further, they neither have mandated pre-emption funds, nor access to last resort emergency lending. Therefore a crisis can be handled only if mechanisms/ institutions providing and ensuring timely and adequate inter-regulatory co-operation are in place.

• During the initial phase of growth of the insurance sector, Unit Linked Insurance Plans (ULIPs) were seen to be somewhat analogous to the Equity Linked Savings Scheme (ELSS) and similar mutual fund schemes. ULIPs are issued by insurance companies (regulated by IRDA), mutual fund schemes are issued by mutual funds (regulated by SEBI). Thus, insurance companies and mutual funds operate under different regulatory regimes with separate prudential norms. New guidelines issued by IRDA in 2006 have stopped ULIPs from being positioned as short-term investment product. In order to ensure that these two different saving instruments with short and long-term investment objectives are positioned appropriately to reflect the respective position, steps are being taken towards inter-regulatory co-operation on an on­going basis.

The Panel noted that there exists a formal information sharing platform in the form of a High Level Co-ordination Committee on Financial Markets (HLCCFM) comprising the Governor of the Reserve Bank, chairman of SEBI, IRDA and PFRDA and the Finance Secretary, Government of India, which serves as a forum for discussing common regulatory issues.

• Also, the Reserve Bank had constituted a Working Group to advise on a special monitoring system for systemically important financial intermediaries (SIFIs also known as financial conglomerates or FCs). The Group, in its report submitted in May 2004 suggested criteria for identifying financial conglomerates, a monitoring system for capturing intra-group transactions and exposures amongst such conglomerates and a mechanism for inter-regulatory exchange of information in respect of conglomerates.

This oversight framework is complementary to the existing regulatory structure i.e., supervision of individual entities by respective regulators, viz., the Reserve Bank, SEBI and IRDA and the system of consolidated financial statements/consolidated prudential reporting applicable to banks. The details of intra-group transactions and exposures to some important market segments such as debt and inter-bank and non-fund based exposures are monitored through the returns prescribed by the financial conglomerates monitoring mechanism. An analysis of the returns, follow- up action thereon and quarterly discussions with the CEOs of the entities belonging to the Groups is currently being looked after by the Financial Conglomerates Cell located in the Reserve Bank. In addition, the Reserve Bank and SEBI have jointly put in place an integrated system of alerts which would piece together disparate signals from different elements of the market.

However, it is possible that there may be some entities in the conglomerate that do not fall under the regulatory/supervisory ambit of any single regulator. These may conduct many internal transactions and such intra-conglomerate cash flows can remain invisible. Such conglomerates can pose systemic threats to stability. Therefore, there should be adequate mechanisms for the relevant agencies to issue regulations and enforce supervisory actions as necessary. In this context, the Reserve Bank has initiated a move to insert a new clause 29 A under the Banking Regulation Act, 1949, which would give it powers to inspect the books of accounts and other records of all entities that are subsidiaries/associates of a bank, irrespective of whether the subsidiary / associate is under any other regulator. A similar change in law may also be appropriate for the other regulators (specifically SEBI and IRDA) who may require inspecting the books of accounts and other records of subsidiaries/ associates of the regulated entity.

The Panel feels that despite such mechanisms, there are areas where inter-regulatory co-operation needs to be strengthened further. It is necessary that the HLCCFM should be given the responsibility of ensuring close co-ordination and monitoring of markets by the respective regulators and transactions and the functioning of conglomerates. The following steps can be taken in this regard:

(i) The HLCCFM should be supported by a formal institutional mechanism enabling it to give directions to regulatory authorities on issues cutting across regulatory domains.

(ii)   The role of the HLCCFM and its functions should be clearly delineated and placed in the public domain.

(iii) The membership of the HLCCFM should be made more broad-based and diversified and market participants should also be represented. As representation by market participants could sometimes lead to a conflict of interests, such participation should be through representative bodies of the industry or the SROs, to ensure that it remains objectively constructive.

(iv) The frequency of the meetings of the HLCCFM needs to be increased.

The Panel also critically considered the feasibility of unified regulation in the Indian context. It was of the view that a unified regulator is not entirely suited to the present state of the country’s overall financial system and its markets. It observed that though the presence of a unified regulator could reduce regulatory overlaps and address the regulatory gaps in the system, for the present it would be best not to go beyond common guidelines. Depending on its primary function, the regulated entity should be regulated by a ‘lead regulator’ who exercises regulatory and supervisory authority in relation to the entity’s primary function. As part of this, supervision of entities with multifarious activities that cut across regulatory domains could be conducted collaboratively with other regulators. For instance, the lead regulator could have the option of requesting other regulators in the supervisory process to comment upon any specific aspects. Further, in order to make such collaborative supervision effective, every effort should be made to ensure that the parameters of such co-ordination are well defined and that ground rules are specified.

2.6 Home-host Country Co-operation

Just as it is crucial to foster greater co­operation among domestic regulatory agencies, it has become increasingly important to promote greater and more effective cross-border collaboration among regulators as the financial sector assumes global dimensions. In the Indian context, though there has been an exchange of supervisory information on specific issues between the Reserve Bank and a few other overseas banking supervisors/ regulators, no formal/ legal arrangement or Memorandum of Understanding (MoU) has been entered into between the Reserve Bank and outside supervisory authorities for cross-border supervisory co-operation. This is partly because of the legal impediments to sharing of credit information and permitting an agency other than the Reserve Bank to inspect a bank in India.

SEBI has established information sharing mechanisms for sharing information with domestic and foreign regulators. As regards its foreign counterparts, SEBI has signed MoUs with foreign regulators of many countries. SEBI may extend informal assistance to foreign regulators in conducting enquiries or investigations of domestic-regulated entities.

IRDA approaches its counterparts in other countries as part of the due diligence examination process of foreign joint-venture partners of proposed new insurers while considering applications for registration of insurers in India. It also interacts with other supervisors to draw on their experiences related to regulatory supervision or to gain insights on issues which do not have precedence in the host country. However, in instances such as informing the home regulator in advance of taking action that affects the parent company, observance has not been tested.

The Panel feels that there should be specific provisions in the RBI Act, 1934 and Banking Regulation Act, 1949 and IRDA Act, 1999 along the lines of SEBI Act, 1992 so that a MoU can be entered with the foreign supervisors, thus establishing a formal communication mechanism.

2.7 Reducing the Scope for Regulatory Arbitrage

In India, NBFCs are important components of the financial services sector. They provide financial intermediation and contribute significantly to economic growth. While the range of activities by NBFCs which are bank subsidiaries are under the control of the Reserve Bank, other NBFCs can undertake activities that are not permitted to be undertaken by banks or which banks are permitted to undertake in a restricted manner (e.g., financing of acquisitions and mergers, capital market activities, etc.). Such differences in the level and intensity of regulation create scope for regulatory arbitrage by routing transactions through NBFCs instead of banks to avoid bank regulation. This is particularly relevant for a banking group/financial conglomerate. Also, there could be regulatory gaps in intra-group transactions and exposures between NBFCs and their parent entities.

To address the concerns that arise out of the divergent regulatory requirements for various aspects of functioning of banks and NBFCs, in December 2006 the Reserve Bank brought out regulatory guidelines by reclassifying NBFCs. For the purpose of regulation, NBFCs are now divided into deposit taking NBFCs (NBFCs-D) and non deposit taking NBFCs (NBFCs-ND) of which NBFCs-ND with the size of Rs.100 crore or more are considered systemically important and are subject to prudential regulation which includes capital adequacy and exposure norms. The other main category of NBFCs is the residual non-banking companies (RNBCs).

The ownership structure of NBFCs can be categorised under the following four broad heads:

(i) Stand -alone NBFCs;

(ii) NBFCs which are subsidiaries/associates/ joint ventures of banking companies;

(iii) NBFCs and banks which are under the same holding company, i.e., sister concerns; and

(iv) NBFCs which are subsidiaries/associates of non-financial companies.

There appears to be no scope for regulatory arbitrage of stand-alone NBFCs. But there does exist a difference in regulatory treatment inasmuch as NBFCs which are part of a banking group are subject to stricter prudential norms in respect of their scope of activities. For example, stand-alone NBFCs can offer discretionary portfolio management schemes which cannot be offered by NBFCs within a banking group. At the same time, it must to be appreciated that NBFCs which are part of a banking group have recourse to cheaper funding sources because of parent banks’ ability to raise low cost deposits. The Panel feels that from the prudential standpoint, the regulatory structure should duly recognise both the advantages and disadvantages of operational environment of respective NBFCs.

Regulatory arbitrage of NBFCs which are subsidiaries/joint ventures/associates of bank holding companies has been addressed to a significant extent through the introduction of consolidated supervision and the stipulation of capital requirements for the banking group as a whole. Mandatory regulatory limits on sensitive exposures (e.g., capital market exposure) for the banking group as a whole have also been prescribed. Further, inspection of banks by the Reserve Bank provides for the ‘review’ of the ‘overall activities’ on a group-wide basis in respect of the banking group. It should, however, be noted that sister concerns, i.e., banks and NBFCs under the same holding companies, do not fall within the ambit of consolidated supervision. To address this gap, the Reserve Bank, IRDA and SEBI are developing a process for regulation and supervision of financial conglomerates. Under the current financial conglomerate monitoring mechanism, banks which have been termed ‘designated entities’ submit information to the supervisory department of the Reserve Bank on group-level issues, and also in respect of individual entities of the group. Some of the group-level information submitted to the Reserve Bank relates to intra-group transactions, exposures and capital adequacy. Similarly, IRDA has also been assigned lead responsibility where an insurance company is the major player along with companies in the Asset Management sector. The process of forming an appropriate structure for regulation and supervision with apposite legislative authority, which is under progress, needs to be expedited.

Other than requirements prescribed for listed entities, non-financial companies are currently not within the purview of financial regulation. In view of the existing intra-group linkages, the Panel feels that the possibility of bringing non-financial entities which have financial subsidiaries/associates or are sister concerns within the same holding company, the scope of supervision of financial conglomerates needs to be examined. Regulatory and supervisory reach has to extend to all those unsupervised entities whose condition could affect the supervised entities.

There could be arbitrage issues regarding both institutions and markets across the regulatory jurisdictions of the Reserve Bank, SEBI and IRDA. If a level playing field and a competitive environment is to be maintained across markets and institutions, duly taking into account the operational objectives and differences in nature, the present arrangement of inter-regulatory co-ordination needs to be strengthened and made transparent.

The Panel strongly feels that a well-established co-ordinating mechanism for the financial system as a whole would be most beneficial in the current circumstances. Inter-regulatory co-operation and a collaborative approach would result in most of the advantages available in unified regulation without exposing the system to its pitfalls.

2.8 Synergies between Regulation and Supervision and Promotion of Financial Stability

The Reserve Bank is the monetary authority as well as the regulator and supervisor of banks and financial institutions. Regulation of money, government securities and foreign exchange markets also come within the scope of activities of the Reserve Bank. This puts the Reserve Bank in a position of advantage regarding information flow from regulator and supervisor to the monetary authority and vice versa. According to the Chairman¹ of the Federal Reserve Bank of Boston, effective exploitation of synergies between the regulator, monetary policy maker and Lender of Last Resort (LoLR) is advantageous from the stability perspective, as their roles often become blurred during crises or periods of significant illiquidity.

The Panel admitted that though the dual roles of monetary authority and regulator and supervisor of banks and FIs have some scope for conflict, in the Indian context the issue has been resolved to a great extent. This is because within the Reserve Bank, a separate Board for Financial Supervision (BFS)² , a committee of the Reserve Bank’s central board of directors, is specifically entrusted with the responsibilities of financial supervision, including banking supervision. The BFS ensures an integrated approach to supervision of commercial banks, development finance institutions, non-banking finance companies, urban co-operatives banks and primary dealers. The Panel feels that the current structure of the Reserve Bank as the monetary policy maker, LoLR and regulator and supervisor, though quasi-independent, is appropriate and may continue. It reduces the information risk that would otherwise be embedded between the monetary authority and regulator and supervisor.

2.9 Institutional Infrastructure

Legal Issues

The failure of co-operative banks and rescue measures in this sector continues to be an area of considerable concern mainly on account of dual control of these entities by the Reserve Bank and State Governments.

Delay in recovery proceedings before debt recovery tribunals (DRTs) results in the locking up of huge amount of public money. Therefore necessary steps are needed to address the delays in the recovery process by increasing the number of debt recovery tribunals. Although the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, has given a major boost to the recovery process of banks and helped them reduce NPAs, the pendency of litigation in India remains a major concern. There is also a need to keep insolvency procedures for entities with systemic risk (like banks/insurance companies) separate from insolvency relating to ordinary companies. The Panel feels that the law should provide for a definite time-frame to conclude liquidation proceedings.

Accounting Standards

The Reserve Bank has issued detailed guidelines on accounting and disclosure norms which require that banks maintain adequate records drawn up in accordance with these accounting policies. The Reserve Bank has laid down asset classification and provisioning norms which have to be adhered to by banks. Banks are required to follow norms for valuation of collateral and this is not reduced from non-performing loans. Financial statements are prepared based on accounting standards prescribed by the ICAI, except for those that have been specifically modified by the Reserve Bank in consultation with the ICAI keeping in view the nature of the banking industry.

It is mandatory for all banks to get their annual accounts audited every year by external auditors who are appointed with the prior approval of the Reserve Bank under Section 30(1-A) of the Banking Regulation Act, 1949. The scope of statutory audit is defined in Section 30 of the Banking Regulation Act, 1949. Auditors are required to report specifically whether the financial statements exhibit a true and fair view of the affairs of the bank under section 30(3) of the Banking Regulation Act, 1949. Banks incorporated in India are required to publish their balance sheet and profit and loss account together with the auditor’s report in a newspaper in circulation at the place where the bank has its principal office. Disclosure standards are reviewed by the Reserve Bank by critically analysing balance sheet formats, accounting policies and disclosures forming part of financial statements. The Reserve Bank has powers to penalise banks in the event of wrong data being furnished by banks in off-site returns and balance sheets. As regards derivative accounting, Accounting Standards along the lines of IAS 30 and 32 would be recommendatory from April 1, 2009 and mandatory from April 1, 2011.

¹Speech by Mr. Eric S Rosengren, President and CEO, Federal Reserve Bank of Boston on Bank Supervision and Central
Banking : Understanding Credit During a Time of Financial Turmoil.

² Constituted by the Bank’s Central Board (RBI {BFS} Regulations, 1994 as a part of delegated legislation as per Regulation
under sub -section (i) of Section 58 of the RBI Act 1934.

Given the increase in derivatives activities in Indian financial markets, an earlier adoption of IAS 30 and 32 would have been preferable. The Panel recommends that in order to encourage corporates to adopt the revised Accounting Standards at an early date (earlier than 2011), it would be desirable that banks enter into derivative contracts with only those corporates who adopt the revised accounting standards.

The Institute of Chartered Accountants of India (ICAI), establishes accounting and auditing standards for companies including listed companies. ICAI has constituted Accounting Standards Board (ASB) and Auditing and Assurance Standard Board (AASB) for this purpose. SEBI is member of both the Committees. Both these Boards adopt International Standards as a base to formulate standards for accounting and auditing and assurance services.

Oversight mechanism, so far as formulation of accounting standards are concerned, was introduced in 2001 through establishment of National Advisory Committee on Accounting Standards (NACAS) under the Indian Companies Act, 1956. This is an independent Committee and accounting standards formulated by ICAI are notified by Government for adoption by companies on the basis of advise of NACAS. Central Government has issued Company (Accounting Standard) Rules, 2006 vide notification dated 07 December, 2006 u/s 211(3C) of the Companies Act, 1956. As per Section 211(3A) it is mandatory for every company to comply with the accounting standards as prescribed under the Accounting Standard Rules, 2006. Clause 50 of Listing Agreement makes it mandatory for listed companies to follow Accounting Standards Issued by Institute of Chartered Accountants of India (ICAI).

ICAI has proposed to move to International Accounting Standards, i.e. International Financial Reporting Standards (IFRS) from April 1, 2011 for public interest entities which includes listed companies. The financial statements of all companies, whether listed or unlisted, must be audited by members of ICAI who are obliged to perform audit in accordance with Auditing and Assurance Standards issued by ICAI. ICAI is moving fast to pronounce assurance and auditing standards on all subjects on which International Standards are issued and revising standards when International Standards are modified under the Clarity Project undertaken by the International Auditing and Assurance Standards Board of IFAC.

ICAI has constituted Financial Reporting Review Board (FRRB) which, suo moto, at random, picks up financial statements issued by listed companies to assess compliance with Accounting Standards in preparation and presentation of financial statements. Non-compliance noticed during review are reported to relevant regulatory authority. The report of FRRB is required to be submitted to the regulator and the regulator should be empowered to deal with such reports and take steps as may be appropriate in the facts and circumstances of the case. When financial statements with qualifications are submitted by regulated entities, mechanism be established to take steps to resolve the differences and to ultimately, do away with such differences.

As regards financial accounting and reporting, insurers are required to comply with provisions of Insurance Act, 1938; IRDA (Preparation of Financial Statements and Auditor’s Report of Insurance Companies) Regulations, 2002 and various circulars issued by IRDA from time to time on specific operational issues. As per the stipulations laid down, all insurers are required to file the annual accounts with the Authority which comprise of the Balance Sheet and Profit and Loss Account (shareholders’ A/c), segment-wise Revenue Account (Policyholders’ A/c) and the receipts and payments A/c on the direct method basis.

The books of every insurer are subject to annual audit. The accounts are required to be prepared are in conformity with the Accounting Standards (AS) issued by the ICAI. Any variations from the same are laid down in the regulations. The IRDA is further vested with the powers to decline to accept the returns in case these are found to be inaccurate or defective. The Authority further examines the issues which arise through off-site inspections, through targeted on-site inspections.

In the adoption of the Accounting Standards, there is no major separate distinction for insurers. As regards the evolving standards on fair value accounting, insurance contracts are still outside the purview of the proposed AS30. Against the background of the Council of the ICAI to achieve full convergence towards the International Financial Reporting Standards (IFRS) by 1st April, 2011, the IRDA is examining the issues in the particular context of the insurance sector and has initiated steps to lay down the way forward.

Liquidity Infrastructure

Recent events like the sub-prime crisis and the treatment of Northern Rock in UK and Bear Sterns in US have highlighted the need for more careful management of liquidity risk. Section 17 of the RBI Act, 1934 empowers the Reserve Bank to grant advances to scheduled banks by rediscounting the bills of exchange and to grant advances to various entities notified by the Central Government. Further, Section 18 of the RBI Act, 1934 empowers the Reserve Bank to purchase, sell or discount any bill of exchange or promissory note although it may not be entitled to purchase or discount or make loans or advances to any entity in case of a special occasion.

Although the existing provisions in the RBI Act, 1934, empower the Reserve Bank to provide liquidity in times of crisis, the Panel feels that the recent global financial turmoil has necessitated the need to examine its conventional role of LoLR. Given the increasing integration of global markets and innovations taking place, conventional methods of a LoLR may not be sufficient, as is evident from the recent crisis. Accordingly, it recommends that the Reserve Bank may consider constituting a Working Group to look into the gamut of issues relating to liquidity with a specific mandate to look into (i) powers available as per extant provisions with the Reserve Bank as regards its role of LoLR (ii) the scope for putting in place a mechanism whereby the same can be activated at the shortest possible notice and (iii) the scope for expanding instruments permitted for providing liquidity.

Chapter III

Background

1.1 Basel Core Principles as a Benchmark

The development of criteria against which supervisory systems can be assessed took shape in the late 1990s with the work commissioned by the Basel Committee on Banking Supervision (BCBS). As a result, the first Core Principles for Effective Banking Supervision was issued in September 1997. Soon after, an attempt was made to survey a large number of countries with a view to assessing the degree of adherence with the new principles in the lead-up to the October 1998 International Conference of Banking Supervisors (ICBS) held in Sydney. The results of the survey pointed to the need for further refinement of the principles and greater rigour both in the detail and the presentation of the Principles. The Sydney ICBS, therefore, called for evolving a more precise and useable form of guidelines. The Committee accordingly issued a revised Core Principles Methodology in October 1999. These principles were refined further in October 2006 by placing greater emphasis on risk management and disclosure. The ICBS in 2006 endorsed the updated version of the Basel Core Principles for Effective Banking Supervision (BCPs) and its methodology.

The BCPs have now become the de facto standard for benchmarking sound prudential regulation and supervision of banks. An assessment of a country’s compliance with the principles acts as a useful tool in the implementation of an effective system of banking supervision. Assessments of observance of the BCPs help in identifying areas that need strengthening and that can contribute to the stability of the financial system directly by improving supervision and indirectly by promoting a robust financial infrastructure. The BCPs seek to ensure that the supervisor can operate effectively and banks can operate in a safe and sound manner. The methodology adopted is objective, detailed and designed to facilitate cross-country comparisons for assessors. But it does not totally preclude the need for subjective judgement.

In the backdrop of the developments, the primary objective of the current assessment is the identification of the nature and extent of compliance to revised BCPs of the supervisory system in India.

1.2 A Review of Earlier Assessments

The FSAP conducted in 2001 by the IMF in respect of commercial banks revealed that based on essential criteria, India was fully compliant with 15 BCPs, largely compliant with eight and materially non-compliant with two, thus leaving none of the BCPs non-complied. However, if both essential and additional criteria are taken into account, India was fully compliant with 15 BCPs, largely compliant with six, materially non-compliant with three and non-compliant with one. The principle-wise assessment is furnished in Appendix 1.

Concurrently, in order to guide the process of implementation of international standards and codes in India and to position India’s stance on such standards, the Reserve Bank (RBI) in consultation with the Government of India (GoI) constituted on December 8, 1999, a Standing Committee on International Financial Standards and Codes. One of the Advisory groups constituted by this Committee looked into banking regulation and supervision. This group evaluated the adherence to Basel Core Principles in respect of regulation and supervision of commercial banks. The recommendations of the Advisory Group are summarised in Appendix 2.

A review committee to monitor progress on recommendations emanating from the above exercise, provided inter alia, in September 2004 a report on banking supervision. This report covered applicability, relevance and compliance with international standards in respect of the Basel Core Principles, corporate governance, internal control, credit risk, loan accounting, financial conglomerates and cross-border banking. This exercise was limited to commercial banks. The review committee’s report on progress made in this regard are summarised in Appendix 3.

1.2.1 Key Developments since 2001

The Reserve Bank has been continually reviewing the prudential supervisory framework, duly taking into account recommendations from earlier assessments. Some of the key developments in this regard related to commercial banks are:

• A fit and proper test is applied to evaluate directors and senior management. Fit and proper requirements for the Board of Directors have also been established through regulation.
• Any transfer of shares in a banking company, (GoI) which exceeds 5 per cent of the paid-up capital of the bank requires acknowledgement by the Reserve Bank before the registration of the transfer in their books.
  
• A Prompt Corrective Action (PCA) framework was introduced by the Reserve Bank in December 2002, linking supervisory responses to three parameters, viz., capital adequacy ratio, net NPA ratio and the return on assets. The PCA framework envisages various structured and discretionary actions by the Reserve Bank at different threshold levels for each parameter.
  
• The Reserve Bank has off-loaded its stake in SBI (2007).
  
• Under the earlier guidelines, if a loan in the doubtful category did not migrate to the loss category, the account remained under-provided because after three years only a maximum of 50 per cent provision was created under the secured portion.
• Under the current guidelines, banks need to make 100 per cent provisioning for the unsecured portion. Provisioning for the secured portion is: 20 per cent upto 1 year, 30 per cent for 1 to 3 years and 100 per cent for more than 3 years.
  
• A detailed circular has been issued in 2007 wherein detailed guidelines on disclosure have been issued for improving the level of disclosure.

1.3 An Outline of the Regulatory Structure of Financial Institutions

In India, the regulatory and supervisory jurisdiction over different segments of the financial system is divided among the three major regulators, viz., the Reserve Bank (RBI), the Securities and Exchange Board of India (SEBI) and the Insurance Regulatory and Development Authority (IRDA), while some overarching regulatory powers vest with the Government of India. A new Pension Funds Regulatory and Development Authority (PFRDA) has also been set up.

The Reserve Bank regulates and supervises the majority of financial institutions in India. Its supervisory power extends to commercial banks, non-banking financial companies (NBFCs), co-operative banks and some All-India financial institutions (AIFIs). The Reserve Bank also licenses and regulates local area banks (LAB), which are treated as commercial banks. The Banking Regulation Act, 1949 (BR Act) provides the regulatory and supervisory framework for banks in India. The Reserve Bank derives its powers to regulate NBFCs and AIFIs through an amendment of the RBI Act in 1997.

The Board for Financial Supervision (BFS) constituted in 1994, which operates as a Committee of the Central Board of Directors of the Reserve Bank, functions as an oversight supervisory body for banks (both commercial and co-operative), NBFCs and AIFIs.

Against this backdrop, Section 2 gives the scope, coverage and methodology of the present assessment and provides a profile of the categories of institutions including commercial banks covered by the assessment. Section 3 attempts to address a set of broad issues arising out of the assessment. Sections

4 to 9 present, respectively, separate assessments of adherence to BCP along with a summary of recommendations related to commercial banks, urban co-operative banks, state and district central co-operative banks, regional rural banks, non-banking financial companies and housing finance companies.

Section 2

Coverage, Scope and Methodology

2.1 Coverage and Scope
The BCPs are basically meant for the assessment of regulatory and supervisory practices with regard to commercial banks and are not strictly applicable to other financial institutions. Recognising, however, the importance of the other segments for the purpose of the current exercise the Panel chose to extend the assessment to urban co-operative banks, rural financial institutions, non-banking financial companies and housing finance companies. Though urban co-operative banks and rural financial institutions are banks, the BCPs are not applicable to them in the strictest sense; as co-operatives, they have a different organisational structure and function with certain broader socio-economic objectives. The non-banking financial companies and housing finance companies do not strictly fall within the ambit of the BCP."

The Panel recognised the difference in the level of development of the various categories of institutions and observed that this difference will have a bearing on the detailed, principle-by-principle assessment. In light of the above, the Panel has viewed the assessments of institutions other than commercial banks largely from a developmental perspective. The approach taken by the Panel in assessing the observance of BCPs in relation to the supervision of entities other than commercial banks:

i In light of the developmental roles played by these institutions and the supervisory environment in which they function, identify separately principles which could be relevant to each of these sectors.

ii Aim at adherence to the applicable principles by treating them as attainable benchmarks.

iii Identify gaps in observance of these benchmarks. and

iv Delineate an action plan for attaining compliance to these benchmarks in the medium-term.

Compared to earlier assessments, this is therefore a broader assessment extending the scope to entities other than commercial banks as relevant. The Panel feels that the results of such assessments would provide important directions to improve the overall regulatory and supervisory framework of all financial institutions. At the same time, the Panel recognises that it would not be appropriate to assess adherence to BCPs in respect of other financial institutions with the same degree of rigour as that of commercial banks. Given the relative importance of commercial banks in the financial system and the developments in the regulatory and supervisory framework covering them, all principles are applicable to commercial banks and a very stringent assessment of the same has been attempted.

2.2 Methodology

The BCPs revised in 2006 contain essential criteria under each principle for the system to be considered effective, and additional criteria for countries to strive to improve financial stability and strengthen supervision. The templates provided jointly by the Bank for International Settlements and International Monetary Fund have been used for the assessment.

While many Basel Core Principles are applicable to any financial system, its exact implementation has to consider the local context, which is shaped by the specific characteristics of local legal and judicial systems, tax policies, regulatory structure, accounting convention and local custom which have been taken into account.

The 25 Core Principles specify the requirements for ensuring sound banking regulation and supervision. Principles 1 lay down conditions related to the objectives, independence, powers and transparency of the regulatory authority. Principles 2-5 lays down criteria related to activities, licensing, ownership and acquisitions. Criteria related to prudential requirements and risk management is detailed in Principles 6-18. Principles 19-21 go into the efficacy of the supervisory process. Principle 22 deals with accounting and disclosure and Principle 23 deals with corrective remedial powers. Principles 24-25 highlight issues relating to consolidated and cross-border supervision.

The level of adherence to each principle has been graded on a four-scale measure as (i) compliant (ii) largely compliant (iii) materially non-compliant or (iv) non-compliant.³ In addition, a principle is considered ‘not applicable’ when it is felt so, given the structural, institutional and legal features of India.

The assessment of Basel Core Principles was completed in February 2008. The Panel

Box 3.1: Basel Core Principles

The Basel Core Principles comprise 25 principles that need to be in place for a regulatory and supervisory
system to be effective. The principles relate to the following:-

³ Compliant: A principle would be treated as compliant if all essential criteria applicable for the country are met without any significant deficiencies. There may be instances, of course, where a country can demonstrate that the compliance to Principle has been achieved by other means.
Largely compliant: A principle would be treated as largely compliant where only minor shortcomings are observed which do not raise any concerns about authoritys ability and clear intent to achieve full compliance with the principle within a prescribed period of time.
Materially non-compliant: A principle would be treated as materially non-compliant whenever there are severe shortcomings despite the existence of formal rules, regulations and procedures and there is evidence that supervision has clearly been not effective, that practical implementation is weak or that shortcomings are sufficient to raise doubts about authoritys ability to achieve compliance.
Non-compliant: A principle would be considered non-compliant whenever there has been no substantive implementation of the principle, several essential criteria are not complied with or supervision is manifestly ineffective.

notes that there have been some developments since then (particularly post implementation of Basel II for a section of the commercial banks) some of which could have assessment implications. The Panel also observes that regulators are already in the process of implementing some of its recommendations The Panel has retained the original assessment with qualifying remarks wherever appropriate.

2.3 Brief Profiles of Institutional Categories covered by the Assessment

2.3.1 Commercial Banks

At the end of March 2007, there were 82 scheduled commercial banks with 59,036 branches. The dominant component of these banks are the 28 state-owned public sector banks which accounted for more than 70 per cent of the total assets in this sector. There were 25 privately owned Indian banks accounting for 22 per cent of the assets and 29 foreign banks operating in India accounting for 8 per cent of the assets. As on March 31, 2007, assets of the scheduled commercial banks constituted 61 per cent of the total assets of the financial system. (The financial system broadly constitutes the banking sector, broder financial sector and co-

operative banks). The balance sheet profile of scheduled commercial banks at end-March 2006 and 2007 is shown in Table 2.

Commercial banks are required to be fully compliant with Basel I norms and are expected to migrate to adoption of Basel II in two phases. Foreign banks operating in India and Indian banks having an operational presence outside India are expected to adopt the revised framework by March 31, 2008 (12 Indian banks with overseas branches and 29 foreign banks have adopted revised framework). All other banks are expected to migrate to Basel II by March 31, 2009.

The performance of the commercial banks has been strong in recent years. Capital adequacy continued to be comfortable at 12.3 per cent as on March 31, 2007, the same as on March 31, 2006. This was well above the stipulated limit of 9 per cent. The ratio of gross NPAs to gross advances and net NPAs to net advances of commercial banks improved from 3.3 per cent and 1.2 per cent as on March 31, 2006 to 2.5 per cent and 1.0 per cent respectively, on March 31, 2007. The return on equity increased from 12.7 per cent as on March 31, 2006 to 13.2 per cent on March 31, 2007 while the return on assets remained at 0.9 per cent during this period.

2.3.2 Urban Co-operative Banks

Urban co-operative banks (UCBs) are an integral and important part of the financial system in India, providing need based quality banking services, essentially to the middle and lower middle classes and weaker sections of society in the urban areas. There were 1,813 UCBs including 53 scheduled UCBs and 1,760 unscheduled UCBs on March 31, 2007. Urban co-operative banks form a heterogeneous group in terms of geographical spread, area of operation, size and individual bank performance. In terms of geographical spread, UCBs are unevenly distributed across the states. As on March 31, 2007, the assets of urban co­operative banks constituted 2.7 per cent of the total assets of the financial system. However, being banks, UCBs are a part of the payments and settlement system and could have a significant contagion impact on financial stability. The sector is significantly compliant as regards Basel I capital adequacy norms with a minimum capital requirement of 9 per cent which is what is stipulated for commercial banks. However, these banks are not required to provide capital charge for market risk in line with Basel requirements. Moreover, provisioning norms are less stringent than internationally adopted best practices.

The business profile of UCBs at end-March 2006 and March 2007 is provided in Table 3.

The CRAR of 1496 out of a total of 1,813 UCBs was more than 9 per cent on March 31, 2007. The ratio of gross NPAs to gross advances of UCBs had declined from 18.9 per cent on March 31, 2006 to 17 per cent on March 31, 2007. The ratio of net NPAs to net advances of UCBs also declined from 8.8 per cent on March 31, 2006 to 7.7 per cent on March 31, 2007. Net profit of scheduled UCBs decreased from Rs.514 crore during 2005-06 to Rs.442 crore during 2006-07. Their accumulated losses declined from Rs.2,032 crore during 2005-06 to Rs.1,996 crore during 2006-07. The performance of the sector thus leaves scope for further improvement.

2.3.3 State Co-operative Banks/District Central Co-operative Banks

The rural financial sector comprises rural co-operative credit institutions and regional rural banks and has a wide outreach particularly among the rural and vulnerable sections of society. The rural co-operative credit institutions can be segregated further into long-term and short-term institutions.The long-term

institutions comprise state co-operative agriculture and rural development banks (SCARDB) and primary co-operative agriculture and rural development banks (PCARDB). The short-term institutions are state co-operative banks (StCBs), district central co-operative banks (DCCBs) and primary agricultural credit societies (PACS). The 31 StCBs and 371 DCCBs, falling under regulatory purview of the Reserve Bank are being covered for the purpose of the present assessment.

The StCBs and DCCBs comprise more than 4 per cent of the total financial sector assets. The profile of these entities on March 31, 2006 is shown in Table 4.

The rural financial sector has been a vulnerable link in the Indian financial landscape. There are a significant number of loss-making entities and the sector is plagued with very high NPA ratios. They are, however, an important component of the financial sector as they are ideally suited for achieving the objective of financial inclusion and together with commercial banks have played a major role in delivery of agricultural and rural credit.

2.3.4 Regional Rural Banks (RRBs)
Regional rural banks were conceived as institutions that combine the local feel and familiarity of co-operatives with the business organisation ability of commercial banks. In the multi-agency approach to agricultural and rural credit in India, RRBs have a special place. Being local institutions RRBs are ideally suited for achieving financial inclusion. The RRBs are jointly owned by the Central Government, State Government and the parent commercial bank. 88 RRBs falling under the regulatory purview of the Reserve Bank are being covered for the purpose of the present assessment.

The RRBs comprise more than 1.8 per cent of the total financial sector assets. The profile of these entities as on March 31, 2007 is shown in Table 5.

2.3.5 Non-Banking Financial Companies
Non-banking financial companies (NBFCs) play a crucial role in broadening access to financial services, enhancing competition and in diversification of the financial sector. They are

increasingly being recognised as complementary to the banking system, capable of absorbing shocks and spreading risks at times of financial distress. NBFCs provide some financial services provided by banks and as such compete with them, albeit not strongly, in so far as sources and application of funds are concerned-for garnering of deposits and in disbursal of loans, advances and investments. NBFCs in India are not permitted to accept demand deposits, are not required to maintain a cash reserve ratio with the Reserve Bank and are not part of the payment and settlement system.

NBFCs have been broadly classified into non-deposit taking NBFCs (NBFC-ND), deposit taking NBFCs (NBFC-D) and residuary non-banking finance companies (RNBCs) which are NBFCs that accept deposits. There were 403 NBFCs-D, 12,617 NBFCs-ND and 3 RNBCs as on March 31, 2007. Since December 2006, NBFC-ND have been further bifurcated into NBFC-ND-Systematically Important (SI) and NBFC-ND-others. This segregation is based on an asset size of Rs.100 crore and above as such companies having public funds for their liabilities and exposure to financial markets are deemed as capable of posing systemic risks.

The profile of these NBFCs as on March 31, 2006 and 2007 is shown in the Table 6.

The asset size of NBFCs has recorded a healthy increase (more than 25 per cent in 2006-07) in recent times primarily aided by the rapid growth in the NBFC-ND segment. At the end of March 2007, NBFCs accounted for around 8.5 per cent of the total assets of the financial system.

Though NBFCs are not part of the payment and settlement systems, their linkages to financial markets and institutions contain elements of contagion risks which are systemically relevant. The stipulated minimum capital adequacy ratio⁴ for NBFC-ND-SI is 10 per cent. The CRAR as applicable to those NBFCs authorised to accept public deposits is:

(i) Asset finance company (AFCs) with a minimum investment grade credit rating (MIGR) – 12 per cent

(ii) AFC companies without MIGR and loan/ investment companies – 15 per cent

It can be seen that the CRAR prescribed for NBFCs is higher than the norms prescribed for commercial banks in India at 9 per cent. However, income recognition, asset classification and provisioning norms applied to them are less stringent than international best practices and when compared to commercial banks. In view of the above, the assessment in their case has been attempted by identifying principles which are relevant to this sector, treating them as attainable points of reference. On this basis, action plans are delineated from a medium-term perspective.

The present assessment covers deposit-taking NBFCs (NBFCs-D) and non-deposit taking systemically important NBFCs (NBFCs-ND-SI).

2.3.6 Housing Finance Companies

Housing finance has grown rapidly in the last two decades and housing finance companies, commercial banks and co-operative banks are together actively involved in this growth. Despite the strong interest and growth shown by commercial as well as co-operative banks in the housing finance sector, housing finance companies remain a significant contributor to housing growth in the country. There are 43 housing finance companies, of which 23 are non-deposit taking. The 12 largest housing finance companies account for about 97 per cent of the outstanding housing loans, 99 per cent of the public deposits and 98 per cent of the total borrowings of the sector.

The profile of the housing finance companies is shown in the Table 7.

As on March 31, 2007, the asset size of the HFCs constituted 2 per cent of total assets of the financial system. Though systemically they constitute a very small component of the financial system, it has been decided to cover the scope of their activities as it is related to real estate which is witnessing a credit boom. Given the predominance of long-term assets in their balance sheets, HFCs could be significantly vulnerable to interest rate risk and adverse selection of assets which, in turn, could affect

the financial system adversely. It is important, therefore, to assess the adequacy of the supervisory environment and its ability to effectively mitigate risks in the event of a cyclical downturn. Though Basel norms are not applicable to HFCs, a minimum capital ratio of 12 per cent (covering only credit risk) has been stipulated for them. The norms related to provisioning are less rigorous than the international standards.

Section 3

Broad Issues

While the assessment of adherence to BCPs has been attempted separately for different categories of institutions, overall, the exercise has brought to the fore certain developmental issues meriting attention. The pros and cons related to such broad developmental issues are detailed in this chapter.

3.2 Ownership Issues

Public sector banks comprise 70 per cent of the assets of the banking sector. On the one hand, this bodes well for stability because of the implicit sovereign guarantee. On the other hand it leads to conflicts of interest as both the regulator and the regulated entities are owned by the government. Undue government influence can lead to poor governance, rendering regulation ineffectual. This has a direct bearing on the regulator’s ability to enforce compliance with the Basel Core Principles. The Panel feels that in the interest of proper regulation and growth of the sector and to resolve the inherent conflict arising from the government owning a major portion of the banking system, the government should urgently consider giving up its role as majority shareholder in public sector banks.

3.3 Implementation of Basel Norms in Respect of UCBs and Rural Financial Institutions

Urban co-operative banks, though compliant with the Basel I accord of 1988 in terms of risk-based capital requirements, have not implemented a capital charge for market risk in line with the BCBS amendment to the first capital accord in 1996. The Panel feels that as some of the scheduled UCBs are equivalent in size and systemic importance to medium-sized commercial banks, there is a need to assign duration-based capital charges for market risk for these entities.

Rural co-operative banks at present do not have any requirement of maintaining risk-based capital. The Panel is of the view that in respect of rural co-operatives, the migration to Basel I can be considered with the implementation of the revival package based on the Vaidyanathan Committee recommendations.

Similarly, in respect of RRBs, implementation of Basel I norms relating to capital adequacy could be considered with the completion of the amalgamation and recapitalisation process of these entities. Also, given the varying status of RRBs and co-operative banks as regards financial health, computerisation, quality of governance, etc., there is need for a selective approach for implementation of the Basel I prescription. The banks could be categorised and a differential time-frame and roadmap could be prescribed for implementation of the Basel I norms.

3.4 Duality in Regulation of Co-operatives

Co-operative banks are regulated and supervised by state registrars of co-operative societies, the central registrar of co-operative societies in case of multi-state co-operative banks and by the Reserve Bank. Rural financial institutions are supervised by NABARD.

Banking-related functions are regulated and supervised by the Reserve Bank and NABARD (as applicable) under the provisions of the Banking Regulation Act, 1949(AACS). This has resulted in RBI/NABARD having no powers to bring about changes in the composition of the Board, to address any prudential concerns, except to requisition the RCS to supersede the board. The Reserve Bank has put in place licensing guidelines and is also empowered to reject applications that do not meet the requisite criteria. The Reserve Bank has prescribed fit and proper criteria for election to the boards of the rural co-operative banks along with criterion for professionalisation of these boards and the CEOs of these banks. While the Reserve Bank has prescribed fit and proper criteria for CEOs of urban co-operative banks, no such criteria have been made applicable to the directors of UCBs.

The Reserve Bank does not have the power to determine the suitability of shareholders, though the registrar of co-operative societies can disqualify the directors. It cannot ensure that the board has sound knowledge of the activities

Box 3.2: Revival Package for Co-operative Credit Institutions

The revival package announced by the Central Government based on the Vaidyanathan Committee recommendations is aimed at reviving the short-term co-operative credit structure (STCCS) to make it a well-managed and vibrant medium to serve the credit needs of rural India, especially, small and marginal farmers. The proposed financial assistance is one time conditional and released only on the implementation of the recommendations for legal and institutional reforms. At the end-january 2008, 17 States which cover 90 per cent of the PACS and 87 per cent of the CCBs in the country have signed a MoU with the Central Government and NABARD.

Financial assistance is available for wiping out accumulated losses, covering invoked but unpaid guarantees given by State Governments and other dues to the CCS from them and increasing capital to a specified minimum level (of 7 per cent CRAR). In order to ensure that the CCS continues on sound financial, managerial and governance norms, technical assistance will also be provided to upgrade institutional and human resources of the CCS. The liability for funding the financial package will be shared by the Central Government, the State Government and the CCS based on the origin of loss and existing commitments. The total financial assistance under the revival package has been estimated at Rs. 13600 crores.

On completion of the revival package, the co­operative credit institutions are expected to be transformed into institutions that (i) are democratic, well-governed, professionally managed and audited; (ii) have requisite autonomy in raising resources and deploying funds as also in other operational matters connected therewith; (iii) undertake financial activities as principal business and separately account for and fund other activities, if undertaken; and that (iv) the StCBs and DCCBs are effectively regulated on par with other entities accepting public deposits.

of the bank. The ability of shareholders to provide financial support cannot be assessed. The Reserve Bank needs to be given more powers to take action against erring management including forced mergers and liquidation.

The multiplicity of command centres coupled with the absence of a clear-cut demarcation between the functions of governments and the Reserve Bank/NABARD has been largely responsible for most of the difficulties in implementing regulatory measures with the required speed and urgency impeding effective supervision.

Pending extensive changes in various legislations, the Vision Document for the UCB sector provided for a two-track regulatory framework and an Memorandum of Understanding (MoU) between the Reserve Bank and other regulators, viz., the State Governments and the central registrar of co­operative societies to ensure that the difficulties caused by dual control are addressed if not fully at least substantially through such MoU/s within the extant legal framework. The Task Force to look into the short-term rural co-operative credit institutions also recommends a similar MoU with State Governments in this regard. The efficacy of these MoUs is however, still to be established beyond doubts.

In respect of rural co-operatives, the Central Government had appointed a Task Force under the Chairmanship of Prof. A Vaidyanathan in 2004 to analyse the problems faced by rural co-operatives and to suggest an action plan for their revival. Based on the report of the Task Force (Vaidyanathan Committee), a revival package for the rural co-operative sector was formulated.

From the long-term perspective, the Panel suggests that government influence in the co­operative sector needs to be minimised and its regulation should be brought within the ambit of a single regulatory organisation. The Reserve Bank with its store of regulatory experience is best placed to be entrusted with this task. Till this is achieved, efforts to sign MoUs should continue with all State Governments and to chalk out a revival path for potentially viable institutions and a non-disruptive exit route for non-viable ones.

3.5 Licensing of Co-operative Institutions

Section 7 of the Banking Regulation Act, 1949 As applicable to Co-operative Societies (AACS), prohibits the use of the words ‘bank’, ‘banker’ or ‘banking’ by any co-operative society other than a co-operative bank as part of its name. However, this provision does not apply to primary agricultural credit society (PACS) or a primary credit society (PCS). The licensing criteria for banks which are consistent with ongoing supervision are laid down clearly in Section 22 of the Banking Regulation Act (AACS), 1949. The Act provides for automatic conversion of primary credit societies with banking as one of its main activities into primary (urban) co­operative banks. Although they are required to apply to the Reserve Bank within three months of attaining capital -plus reserves of Rs. 1 lakh for a licence under Section 22 of the Banking Regulation Act(AACS), 1949 , they can carry on banking business unless the licence application is refused. This has led to the presence of a large number of unlicensed banks.

There are around 309 StCBs and DCCBs and 79 UCBs which are currently operating without a banking license. The Panel expressed concern regarding the continuing existence of

Box 3.3: Dual control and Progress in Streamlining the Dual
Regulatory & Supervisory Control of UCBs

1. Legislative framework

The issue of dual control has been cited as the single most important impediment to effective regulation and supervision. Urban Co-operative Banks (UCBs), being primarily co-operative societies, are governed by the provisions of respective State Co-operative Societies Acts and Multi-State Co-operative Societies Act, as the case may be, apart from the Banking Regulation Act, 1949(AACS). The powers in regard to incorporation, registration, management, amalgamation, reconstruction or liquidation are exercised by the Registrar of Co-operative Societies under the respective Co-operative Societies Act of the State or by the Central Registrar of Co-operative Societies in case of the multi-state urban co-operative banks. Banking related functions such as issue of licenses to start new banks/branches, matters relating to interest rates, loan policies, investments, prudential exposure norms, etc., are regulated and supervised by the Reserve Bank under the provisions of the Banking Regulation Act, 1949(AACS).

2. Problems in dual control

A few illustrations, indicating severity of the problem are given below:

(i) The Reserve Bank has no authority to deal with delinquent management in a co-operative bank, this requires intervention of the RCS.

(ii) In some states, UCBs are required to obtain a No Objection Certificate (NOC) from the RCS even after getting the branch license from the Reserve Bank.

(iii) Making investments out of surplus resources needs the approval of the Registrar in some states.

(iv) There are instances where on requests from the Reserve Bank, the Registrar superseded the Board of a co-operative bank. But, subsequently, the State Government in its wisdom annulled the Registrar’s orders and restored the board.

3. Recommendations of the High-Powered Committee

The High-Powered Committee on Urban Co­operative Banks recommended carrying out amendments in the State Co-operative Societies Acts, Multi-state Co-operative Societies Act and also in the Banking Regulation Act, 1949(AACS), clearly demarcating the functions which are to be regulated solely by the Reserve Bank and those of the establishment of co-operative societies and their co-operative characteristics, which shall remain within the domain of the Registrar of Co-operative Societies of the concerned states. Accordingly, a draft legislative bill proposing certain amendments to the Banking Regulation Act, 1949, has been forwarded to the Central Government. The proposed amendments, inter alia, relate to:

(i) preventing automatic conversion of primary credit societies to primary co-operative banks;

(ii) empowering the Reserve Bank to cause special audit of UCBs whenever it is satisfied that it is necessary in the public interest or in the interests of the co-operative bank or its depositor, for such transactions or class of transactions or for such periods as may be specified in the order.

4. Recent measures to overcome the complexities posed by dual control-‘Vision Document’ for the UCB Sector:

unlicensed co-operative institutions as these entities pose a risk to depositors’ interests. There is a need to draw up a roadmap whereby “banks” which fail to obtain a license by 2012 will not be allowed to operate. This would expedite the process of consolidation and weeding out of non-viable entities from the co­operative space.

3.6 Enhancement of Efficacy of Off-Site Monitoring through close co-ordination with On-Site Supervision

The Reserve Bank monitors commercial banks and other financial institutions within its regulatory ambit through on-site inspection and off-site surveillance. Its powers are derived from the Banking Regulation Act, 1949. The Panel observed that there is need as well as room for enhancement of co-ordination between on-site inspections and off-site surveillance to exploit fully the synergies arising out of the complementarity of these two forms of supervision. Suitable measures to achieve this objective are called for as these will add substantially to effective supervision.

3.7 Regulatory Independence of NABARD and NHB

Section 7(3) of the NABARD Act, 1981, states that the Central Government may, in consultation with the Reserve Bank remove the Chairman at any time before the expiry of his term of office. Section 8(2) of the NABARD Act, 1981 states that the Central Government may, in consultation with the Reserve Bank, remove the Managing Director or any whole-time director appointed under sub-section (3) of section 6, at any time before the expiry of his term of office, after giving him a reasonable opportunity of showing cause against the proposed removal. However, the Act is silent about the public disclosure of reasons for the removal of the head of supervisory authority. Similarly, there is no requirement for a public disclosure of the reasons for the removal of the head of NHB. Though Section 7 of NHB Act provides for terms of appointment of Chairman of NHB, it states that Central Government can in consultation with the Reserve Bank remove the Chairman after giving him reasonable opportunity of showing cause against the proposed removal.

As NABARD and NHB are not independent regulators, but are being regulated by the Reserve Bank, the Panel feels that the present dispensation regarding removal of heads of these institutions may continue.

Section 4

Commercial Banks

4.1 Legal Arrangements and Organisational set-up for Regulation and Supervision

The Reserve Bank an autonomous body created under an act of the Indian Parliament, i.e., the RBI Act, 1934, is solely entrusted, inter alia with the responsibility of regulation and supervision of banks. The Banking Regulation Act, 1949, empowers it to inspect and supervise commercial banks. These powers are exercised through on-site inspection and off-site surveillance. The Banking Regulation Act, inter alia, which also defines banking activity, specifies licensing requirements and provides for winding-up of banking companies. In addition to inspection of banks, the Act empowers the Reserve Bank to issue directions and impose penalties. The Act is applicable to state-owned, private sector and foreign banks operating in India. In addition, public sector banks are subject to their respective statutes, the State Bank of India (SBI) Act, 1955, State Bank of India (Subsidiary Banks) Act, 1959 and the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 and 1980.

Within the Reserve Bank, a separate Board for Financial Supervision (BFS), a committee of the Bank’s Central Board of Directors, is specifically entrusted with the responsibilities of financial supervision, including banking supervision. BFS has been constituted by the Bank’s Central Board (RBI {BFS} Regulations, 1994 as a part of delegated legislation as per regulation under sub-section (i) of Section 58 of the RBI Act 1934). The Governor is the Chairman of the BFS. The BFS, which generally meets once a month, provides direction on a continuing basis on regulatory policies including governance issues and supervisory practices. It also provides direction on supervisory actions in specific cases. The BFS also ensures an integrated approach to supervision of commercial banks, development finance institutions, non-banking finance companies, urban co-operatives banks and primary dealers. Some of the initiatives taken by BFS include restructuring of the system of bank inspections, introduction of off-site surveillance, strengthening of the role of statutory auditors and strengthening of the internal systems of supervised institutions.

4.2 Summary Assessment of Commercial Banks

For the purpose of this assessment, the 25 Basel Core Principles for regulation and supervision of institutions have been broadly categorised as under:

(i) Objectives, autonomy and resources (Principle 1)
(ii) Licensing criteria (Principles 2-5)
(iii) Prudential requirements and risk management (Principles 6-18)
(iv)  Methods of ongoing supervision (Principles 19-21)
(v) Accounting and disclosure (Principle 22)
(vi) Corrective remedial powers (Principle 23)
(vii) Consolidated and Cross border banking (Principles 24-25)

The summary assessment of adherence to Basel Core Principles in respect of regulation and supervision of commercial banks under the above mentioned broad categories is given below. The detailed principle-wise assessment of Basel Core Principles of commercial banks is furnished in Appendix 4.

4.2.1 Objectives, Autonomy and Resources (Principle 1)

All sub-components of the principle, except the one on independence, accountability and transparency, are fully compliant. The Reserve Bank which regulates and supervises commercial banks has clear responsibilities and objectives, transparent processes, sound governance and adequate resources. Over the years, by convention and practice, it has established its operational independence de facto, even though there are some legislative gaps in ensuring de jure independence inasmuch as the Central Government has powers to remove the head of the supervisory authority without specifying any reasons. It is only indirectly accountable to Parliament through the executive wing of the government. The accountability framework needs to be better delineated and made more transparent.

The responsibilities and objectives of the supervisory authority are clearly defined. It possesses sound governance and adequate resources to be accountable for the discharge of its duties. There is a suitable legal framework in place in the form of a Banking Regulation Act, 1949, which includes provisions relating to licensing of banks (Section 22), setting prudential rules and their ongoing supervision (Section 35). The extant legislation also empowers the supervisor to assess compliance with laws and regulations to ensure the safety and soundness of banks, to have access to banks’ board, management, etc., and to take action against banks indulging in unsound practices. Legal protection is provided for supervisors as per Section 54 of the Banking Regulation Act, 1949.

The Reserve Bank has arrangements in place for sharing of information with domestic regulators. As the law does not empower it to enter into formal Memoranda of Understanding (MoUs), there are no formal MoUs with foreign supervisory agencies. However, it shares information with overseas supervisors based on reciprocity and with clear understanding that the information will remain confidential and be used for the purpose for which it is sought.

The international banking scene has witnessed a strong trend towards globalisation and consolidation of the financial system. Supervisory processes have also evolved and acquired a certain level of robustness and sophistication with the adoption of the CAMELS/ CALCS* approach to supervisory risk assessments and rating. The Reserve Bank has been constantly endeavouring to enhance the sophistication and efficiency levels of its supervisory processes. Considering the growing diversities and complexities of banking business, the spate of product innovation with complex risk phenomena, the contagion effects that a crisis can spread and the consequential pressures on supervisory resources, the Reserve Bank issued guidelines on the adoption of the Risk-Based Supervision (RBS) approach in September 2002. Currently pilot runs in select banks are being undertaken.

The RBS approach essentially entails the allocation of supervisory resources and paying supervisory attention in accordance with the risk profile of each institution. It is expected to optimsze utilisation of supervisory resources and minimsze the impact of a crisis situation on the financial system. The RBS process involves continuous monitoring and evaluation of the risk profiles of the supervised institutions in relation to their business strategy and exposures. This assessment will be facilitated by the construction of a risk matrix for each institution.

The working will be by way of enhancement as well as refining of the supervisory tools over those traditionally employed under the CAMELS approach viz., on-site examination and off-site monitoring. The RBS processes and the outcomes will be forward-looking, focusing attention beyond the rectification of deficiencies with reference to the on-site inspection date. The extent of on-site inspection would be largely determined by the quality and reliability of the off-site data, and the reliability of the risk profile built up by banks. The effectiveness of the RBS would clearly depend on banks’ preparedness in certain critical areas, such as quality and reliability of data, soundness of systems and technology, appropriateness of risk control mechanisms, supporting human resources and organisational back-up. Currently, a comprehensive review of the CAMELS process and RBS system is on to evolve a typical framework for India which, while being risk-based, would also fulfil the statutory obligations on the part of the Reserve Bank to assess the real and exchangeable value of assets, and to ensure that the bank holds the minimum statutory and regulatory capital on the dates of assessments. At the same time, the supervisory framework, which as per the Core Principles, needs to follow certain objective mechanisms to ensure the allocation of resources as per the risk profiles of banks, will also have to be enabled to undertake the Supervisory Review and Evaluation Process (SREP) under Pillar 2 of Basel II. The said review attempts to integrate SREP with the ongoing regular supervisory framework.

In light of recent developments in the international arena, the Reserve Bank is reviewing its stance on RBS.

Source: RBI circular on Risk Based Supervision

* CAMELS – Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Systems and Control

* CALCS – Capital Adequacy, Asset Quality, Liquidity, Compliance and Systems and Control

4.2.2 Licensing Criteria (Principles 2-5)

All the principles relating to licensing criteria are compliant. The Banking Regulation Act, 1949 delineates the situations under which the word ‘banking’ can be used (Section 7) and permissible activities (Section 6) that can be undertaken by bank. The licensing criteria for banks which are consistent with ongoing supervision are laid down clearly in Section 22 of the Banking Regulation Act, 1949. The Reserve Bank has powers to reject an application if criteria set by it are not fulfilled by a bank. There are also guidelines in place for the fit and proper criteria in respect of directors and top management. The Reserve Bank has the power to review and reject any proposal to transfer significant ownership or controlling interests held directly or indirectly in existing banks to other parties. Clear rules are laid down regarding major acquisitions by banks.

4.2.3 Prudential Requirements and Risk Management (Principles 6-18)

Some of these principles are aspirational in nature as full compliance can be achieved only post-implementation of Basel II. Of the 13 principles relating to prudential requirements and risk management, three principles relating to capital adequacy, large exposure limits and country and transfer risks are compliant; five principles relating to credit risk, problem assets, provisions and reserves, operational risk, internal control and abuse of financial services are largely compliant; four principles relating to risk management, exposure to related parties, market risk and liquidity risk are materially non-compliant; the principle relating to capture of interest rate risk in the banking book is non-compliant.

Detailed guidelines on capital adequacy covering both on and off-balance sheet items have been issued to banks. The Reserve Bank has issued detailed guidelines on risk management but there is no specific regulatory requirement of an internal capital adequacy assessment process, since Basel II norms have not yet been implemented. (The Reserve Bank has since issued guidelines on the internal capital adequacy assessment process as part of the supervisory review process under Pillar II of Basel II which is currently applicable to banks with overseas operations and foreign banks. The guidelines would be applicable to all other banks from March 31, 2009). Guidelines relating to stress testing have been issued and this has been made mandatory for banks from March 31, 2008. While explicit guidelines regarding information systems for addressing risks and segregation of duties have been issued to banks, the same have not been issued to banking groups.

The guidelines on credit management do not explicitly mention that the bank’s credit risk management policies/strategies include counterparty risk that might arise through various financial instruments. Guidelines on income recognition, asset classification and provisioning do not require banks to make an assessment on an individual basis of large accounts which are substandard even if they are unsecured. There are guidelines on large exposures in place. The Reserve Bank has issued guidelines on related parties. However, the discipline of seeking prior approval of the Board does not apply to all transactions (other than lending) and there is no requirement of seeking prior approval of the Board for write-offs.

The Reserve Bank has issued detailed guidelines on country risk. Likewise, it has issued guidelines on market risk. However, the extant guidelines do not require banks’ valuation methods to appropriately capture concentrations, less liquid positions and stale positions which, in turn, should be reflected in provisions held by banks. Liquidity risk is essentially a consequential risk typically triggered by a combination of several other risks, like loss of depositors’ confidence, changes in counterparty risk, changes in economic conditions, fluctuations in interest rates etc. The guidelines on liquidity risk management do not specifically mandate banks to assess the impact of other risks (viz., credit, market and operational risks) on liquidity of the bank. Further, they are confined to rupee balance sheets of banks. Also, the increase in infrastructure financing and real estate exposure of banks has resulted in an increased Asset-Liability Management (ALM) mismatch. Though banks hold a significant portion of their assets in liquid instruments there is a growing dependence on purchased liquidity and an increase in illiquid assets. These require to be strictly factored into the prudential guidelines for liquidity management and, if considered necessary, in the capital requirement of banks. In the Indian context, since the Reserve Bank regulates and supervises banks and is also the LoLR, it is in a position to assess the solvency and liquidity position of banks, hence will be in a position to make judicious use of the LoLR. This helps the Reserve Bank in reducing the incidence of events that cause an aggregate shortage of liquidity and to intervene at the appropriate juncture.

The Reserve Bank has issued detailed guidelines on operational risk to banks.

The asset-liability framework and risk management guidelines include the management of interest-rate risk. However, no specific guidelines have been issued to banks for managing interest rate risk in banking book. (The Reserve Bank has since issued guidelines on interest rate risk in banking book as part of the supervisory review process under Pillar II of Basel II, currently applicable to banks with overseas operations and foreign banks. The guidelines would be applicable to all other banks from March 31, 2009).

The guidelines on internal control issued by the Reserve Bank do not ensure that there is an appropriate balance in the skills and resources of the back office and control functions relative to the front office. They do not require that banks notify the Reserve Bank of any material information that negatively affects the fitness and propriety of a member or of the senior management.

Financial institutions are increasingly using complicated financial instruments. Many of these instruments do not trade through exchanges but as over the counter (OTC) transactions. This is of particular importance in respect of derivatives products. Operational risk in derivatives activities is particularly important, because of the complexity and rapidly evolving nature of some products. The nature of the controls in place to manage operational risk must be commensurate with the scale and complexity of derivatives activity being undertaken. Volume limits may be used to ensure that the number of transactions being undertaken does not outstrip the capacity of the support systems to handle them. A segregation of duties is necessary to prevent unauthorised and fraudulent practices. A basic and essential safeguard against the abuse of trust by an individual is to insist that all staff should take a minimum continuous period of annual leave (say 2 weeks) each year. This makes it more difficult to conceal frauds in the absence of the individual concerned. Policies and procedures should be established and documented to cover the internal controls which apply at various stages in the work-flow of processing and monitoring trades. Apart from a segregation of duties, these include trade entry and transaction documentation, confirmation of trades, settlement and disbursement, reconciliation, revaluation, exception reports, accounting treatment and an audit trail.

The Reserve Bank is satisfied that banks have adequate policies and processes in place including strict KYC rules.

4.2.4 Methods of Ongoing Supervision (Principles 19 -21)

The supervisory framework for commercial banks is largely in place. Of the three principles relating to methods of ongoing supervision two relating to supervisory techniques and supervisory reporting are largely compliant. The principle related to the supervisory approach is treated as materially non-compliant as the present rating mechanism (CAMELS for domestic banks and CALCS for foreign banks) does not clearly reflect the risk profile of banks. There is no requirement of notifying the Reserve Bank of any substantive changes/ adverse developments in a bank.

The Reserve Bank employs both on-site and off-site supervision while conducting supervision. It has the means for collecting, reviewing and analysing prudential reports and statistical returns from banks both on a solo and consolidated basis.

Box 3.6: Prompt Corrective Action

Banking failures across countries during 1980 and 1990s led to the search for appropriate supervisory strategies to avoid bank failures as they can have a destabilising effect on the economy. In both industrial and emerging market economies, bank rescues and mergers are more common than outright closure of banks. It is therefore essential that corrective action is taken well in time when the bank still has an adequate cushion of capital, to minimise the cost to the insurance fund / public exchequer in the event of a forced liquidation of the bank. In this context, supervisory action can be at two levels:

* early recognition of problems and corrective actions
* supervision and monitoring of troubled banks

Identifying problem banks early is one of the responsibilities of bank supervisors. The other responsibility is to initiate corrective action in an attempt either to prevent failure or to limit losses.

These objectives are sought to be achieved by establishing various trigger points and graded mandatory responses by supervisors. This represents partial replacement of regulatory discretion by rules, as the prescribed actions are generally likely to be a mix of mandatory and discretionary actions. The Financial Sector Assessment Programme (FSAP), jointly made by the International Monetary Fund and the World Bank team on India’s compliance with the Basel Committee’s Core Principles in 2001 highlighted that lack of explicit rules mitigating against supervisory forbearance is a major weakness and that the time limit set by the Reserve Bank for taking remedial measures is too long.

The Reserve Bank has been taking bank-specific supervisory corrective actions where the financial position warrants such measures. These included directing banks to submit quarterly Monitorable Action Plans and progress reports on various targets set by the Reserve Bank, such as augmentation of capital, improvement in profitability, reduction of NPAs, reconciliation of entries in inter-branch, inter­bank and nostro accounts, review/renewal of borrowal accounts, etc. Though there are explicit provisions empowering the Reserve Bank to initiate appropriate corrective action against banks which show signs of distress, these are not properly structured and no time limit is set for a response to such actions in the case of definite weaknesses in banks. Accordingly, a prompt corrective action scheme was formulated in March 2001 which involved a schedule of corrective actions based on three parameters, i.e., CRAR, net NPAs and return on assets (RoA), which represent capital adequacy, asset quality and profitability.

There are triggers prescribed in respect of each of the three parameters and on hitting the trigger a set of mandatory and discretionary PCAs would be initiated against the bank that has hit the trigger. The rationale for classifying the rule-based action points into mandatory and discretionary action points is that some actions are essential to restore the financial health of banks while other actions will be taken at the discretion of the Reserve Bank depending on the profile of the bank.

Source: RBI Circular on Prompt Corrective Action

But it has no power to initiate inspections in respect of a banking group.

4.2.5 Accounting and Disclosure (Principle 22)

The principle relating to accounting and disclosure is largely compliant. External experts are required to bring to the notice of the Reserve Bank any serious irregularities noticed by them in the working of a bank that requires immediate attention. The Reserve Bank ensures that each bank maintains adequate records drawn up in accordance with accounting policies and practices that are widely acceptable internationally, and publishes on a regular basis information that fairly reflects its financial condition and profitability. The extant guidelines do not require banks to make qualitative disclosures on their risk management aspects. Banks at present do not have a formal board approved disclosure policy which would be applicable once Basel II guidelines come into effect from March 31, 2008 (The Indian banks with foreign operations and foreign banks are required to have a formal board-approved disclosure policy with effect from March 2008).

4.2.6 Corrective Remedial Powers (Principle 23)

The principle relating to corrective remedial powers is largely compliant. The Reserve Bank has at its disposal an adequate range of supervisory tools to bring about timely corrective actions. But it does not have the powers to impose penalties/ sanctions on the management and/or the board or individuals therein. Furthermore, there is no specified timetable for initiating actions under the Prompt Corrective Action (PCA) framework.

4.2.7 Consolidated Supervision and Cross-Border Banking (Principle 24-25)

The principle relating to consolidated supervision is largely compliant while the principle relating to cross-border banking is materially non-compliant.

A concept of consolidated supervision is in place whereby banks that have subsidiaries are required to file consolidated financial statements and half-yearly consolidated prudential returns to the Reserve Bank. In India, the holding company of the banking group as per the current corporate structure is the bank itself. Hence, while reviewing the operations of a bank and evaluating its financial health, the supervisor, deriving the necessary powers from Section 35 of the Banking Regulation Act 1935, ‘reviews’ the ‘overall activities’ of the banking group, both domestic and cross-border. Specifically under Section 35 of the Banking Regulation Act, the Reserve Bank enjoys powers to inspect the banking companies of an Indian banking group incorporated abroad. Even otherwise, under the current financial conglomerate monitoring mechanism, banks which have been termed as ‘designated entities’, submits variety of information to the Reserve Bank on group level issues, and also in respect of individual entities of the Group. The on-site inspection reports of the banks include comments on the earning performance of the bank’s subsidiaries and joint ventures. Though the Reserve Bank has the power to define the range of activities of the consolidated group and call for information in respect of any entity in the banking group, it does not have power to cause inspection of all entities in the banking group. There is a formal arrangement in place for sharing information with domestic regulators. However, information exchange with foreign regulators takes place on an informal basis and there are no formal MoUs in place for exchange of information with foreign supervisors as there is no enabling provision in either the RBI Act or the BR Act regarding information sharing.

The Reserve Bank has mechanisms in place for sharing information among domestic regulators through the High-Level Co-ordination Committee on Financial Markets (HLCCFM). Cross-border exchange of information of supervisory interest with host country supervisors is need-based and no formal MoUs exist. There is no formal arrangement with home / host supervisors to exchange information at periodic intervals.

In the absence of such arrangements, it is difficult to assess the adequacy of the information to be exchanged. For instance there is no formal mechanism at present for inspection of bank branches abroad. In the Indian context, though there have been exchanges of supervisory information on specific issues between the Reserve Bank and a few other overseas banking supervisors/ regulators. But no formal/ legal arrangement or Memorandum of Understanding (MoU) has so far been entered into between the Reserve Bank and outside supervisory authorities for cross-border supervisory co-operation. This is partly because of legal impediments with regard to sharing of credit information and permitting an agency other than the Reserve Bank to inspect a bank in India.

Following the failure of large international banks triggered by the operations of their subsidiary ventures and the concerns arising out of the entry of banks into other lines of business, there has been renewed focus on empowering supervisors to undertake consolidated supervision of bank groups. The Core Principles for Effective Banking Supervision issued by the Basel Committee on Banking Supervision (BCBS) have underscored this requirement as an independent principle. Accordingly, a multi-disciplinary Working Group was set up in November 2000 by the Reserve Bank (RBI). The recommendations of the Working Group were examined in the Reserve Bank and it was decided to implement consolidated supervision in respect of banks.

The Working Group has identified the following three components of consolidated supervision:

(a) Consolidated Financial Statements (CFS),

(b) Consolidated Prudential Reports (CPR), and

(c) Application of prudential regulations like capital adequacy and large exposures/risk concentration on a group basis.

All banks coming under the purview of consolidated supervision of the Reserve Bank, whether listed or unlisted were advised to prepare and disclose consolidated financial statements for the financial year commencing April 1, 2002 in addition to solo financial statements. Consolidated financial statements was required to be prepared in terms of Accounting Standard (AS) 21 and other related accounting standards prescribed by the Institute of Chartered Accountants of India (ICAI) viz., Accounting Standard 23 and Accounting Standard 27. For the purpose, the terms ‘parent’, ‘subsidiary’, ‘associate’, ‘joint venture’, ‘control’ and ‘group’ have the same meaning as ascribed to them in the above Accounting Standards of the Institute of Chartered Accountants of India.

A parent presenting consolidated financial statements should consolidate all subsidiaries -domestic as well as foreign - except those specifically permitted to be excluded under Accounting Standard 21. These statements are called from groups where the apex entity is a commercial bank. Non-financial and insurance subsidiaries/associates/joint ventures of the apex bank are outside the ambit of the CFS/CPR. The reasons for not consolidating any other subsidiary should be disclosed in the consolidated financial statements. The responsibility of determining whether a particular entity should be included or not for consolidation would be that of the management of the parent entity; the statutory auditors should comment in this regard if they are of the opinion that an entity which ought to have been consolidated had been omitted.

Consolidated financial statements normally include a consolidated balance sheet, consolidated statement of profit and loss, principal accounting policies, notes on accounts, etc.

There are two specific supervisory processes in place to develop and maintain systems for thorough understanding of the operations of banking groups:

• Financial Conglomerate Monitoring (FCM)

• Consolidated Supervision (CPR & CFS)

The process of Financial Conglomerate Monitoring is being further fine tuned through a project under which various cross-country practices are being studied and typical Indian requirements are being assessed.

Source: RBI Circular on Consolidated Supervision

4.3 Recommendations

In light of the gaps observed in its assessment of adherence to Basel Core Principles on the regulation of commercial banks, the Panel has made certain recommendations to strengthen the regulation and supervision of these entities. These are as under:

4.3.1 Constitution of Bank Boards

As per Section 10A(2)(b) of the Banking Regulation Act, 1949, directors⁵ on a bank’s board should not have substantial interest in a company or firm. As per Section 5(ne) of the Banking Regulation Act, 1949, substantial interest⁶ means a paid-up amount exceeding Rs. 5 lakh or 10 per cent of the paid-up capital of the company, whichever is less. The low amount of Rs. 5 lakh acts as a constraint for having directors with requisite expertise on banks’ boards.

The Panel recommends that these guidelines need to be reviewed and the limits defining ‘substantial interest’ revised upwards so that banks can attract individuals with requisite expertise on their boards.

4.3.2 Internal Capital Adequacy Assessment Process (ICAAP)

The Board of banks have been advised to have approved policy on the Internal Capital Adequacy Assessment Process (ICAAP) and to allocate capital as per the assessment. But progress in this regard is limited to a parallel run of the revised framework. The Internal Capital Adequacy Assessment Process is yet to be implemented.

The Panel expects that this would be implemented consequent to the full migration of commercial banks to the Revised International Capital Framework (Basel II) as stipulated by the Basel Committee on Banking Supervision (The Panel notes that the Reserve Bank has since issued guidelines on the internal capital adequacy assessment process as part of the supervisory review process under Pillar II of Basel II which is currently applicable to banks with overseas operations and foreign banks. The guidelines would be applicable to all other banks from March 31, 2009).

4.3.3 Risk Modelling

In terms of the extant guidelines, the use of internal models for risk management is not specifically mandated. Consequently, there is no system of periodic validation and independent testing of models and systems in the banks.

The Panel feels that a rigorous model-building exercise is needed. This will enable them to adopt a more advanced Internal Rating Based (IRB) approach in respect of credit risk and an Advanced Measurement Approach (AMA) for operational risk. If a bank intends to take recourse to the IRB or AMA approach for assessing credit and operational risks respectively, it should have appropriate forward looking models in place which should be validated periodically. The Panel recognises the need for capacity building in respect of banks and the Reserve Bank as the prime precondition in this regard.

4.3.4 Credit Risk

The Reserve Bank has issued detailed guidelines on credit risk management in October 2002 which includes putting in place policies and processes for identification, measurement, monitoring and control of credit risk. However, the guidelines do not require that banks’ credit risk management policies / strategies should also include counterparty credit risk arising through various financial instruments.

The Panel recommends issuance of suitable guidelines on credit risk to include counterparty risk arising through various financial instruments.

⁵ This is applicable to only 51 per cent directors having specialised qualification.
⁶ Substantial interest in SSIs are excluded.

4.3.5 Provisioning for Sub-standard Loans

(i) The Reserve Bank has issued detailed guidelines on income recognition and asset provisioning. As per extant guidelines, provisioning is not done on an individual basis in respect of the substandard category of NPAs.

The Panel feels that keeping in view the cost of compliance, the present stipulations could continue for the present. However, considering the very large number of low value NPAs which are substandard, if at all provisioning has to be done individual account-wise, a cut-off level should be set above which all accounts can be provided for individually. This cut-off level above which all substandard assets have to be provisioned for may be lowered in a phased manner.

(ii) As per extant guidelines on provisioning, banks are required to make up to two per cent provision on standard assets, while NBFCs do not need to make any provision on standard assets.

The Panel recommends a review of norms be made to reduce the possibility of regulatory arbitrage across categories of financial institutions.

4.3.6 Exposure to the Capital Market

Globally, capital market exposure is measured based on risk and not quantitative limits. However, in India capital market exposure cannot exceed 40 per cent of the net worth, and the limit for lending to individuals is Rs.10 lakh (Rs.20 lakh in demat form) which appears to be low. Further, a uniform margin of 50 per cent is applied on all advances/financing of IPOs/ issue of guarantees on behalf of stockbrokers and market makers.

The Panel recommends a review of these limits periodically keeping in view the associated risks arising out of such exposures.

4.3.7 Liquidity Risk

(i) The Reserve Bank has issued detailed guidelines on liquidity risk and banks have a liquidity management strategy in place. However, the effect of other risks on banks’ overall liquidity strategy is not covered in the guidelines.

The Panel feels that the enhancement of knowledge and quantitative skills in the banking industry is an essential pre-requisite for analysing contagion risk. The banking sector is at a stage where it has initiated the implementation of simple and standardised risk management techniques. An impact analysis of other risks on liquidity at this juncture would therefore appear premature. The Panel also recognises the existence of diverse risk management techniques across the banking sector. It recommends that the implementation of contagion risk management techniques be undertaken in a phased manner. To begin with, it could be mandated for those banks that are in possession of appropriate skill sets. The Panel also recommends that banks should initially concentrate on knowledge and quantitative skill enhancement and fix a reasonable timeframe, say two years, before undertaking such forward -looking analysis of contagion risk.

(ii) The extant guidelines on liquidity risk issued by the Reserve Bank are confined to the rupee balance sheets of banks.

The Panel recommends that the Reserve Bank should consider issuing guidelines on liquidity risk which would also cover foreign exposures of banks.

4.3.8 Operational Risk

Though various aspects relating to operational risk are covered sufficiently in the Annual Financial Inspection reports for commercial banks, there is no reporting mechanism in place whereby the supervisor is kept informed of developments affecting operational risk in banks on an ongoing basis.

The Panel recommends that the Reserve Bank should put in place a mechanism whereby banks are required to report developments affecting operational risk to the supervisor.

4.3.9 Interest rate risk in Banking Book

Commercial banks have migrated to Basel II guidelines in phases beginning March 31, 2008. The identification, measurement, monitoring and control of interest rate risk in banking books is part of the stipulations mandated in Pillar II of the Revised Capital Framework and is not mandated at present.

The Panel recommends that the issuance of guidelines relating to the management of interest rate risk in banking books, post-migration to Basel II could be based on the modified duration approach for the measurement of interest rate risk in banking books as suggested by the Basel Committee (The Panel notes that Reserve Bank has since issued guidelines on interest rate risk in banking books as part of the supervisory review process under Pillar II of Basel II which is currently applicable to banks with overseas operations and foreign banks. The guidelines would be applicable to all other banks from March 31, 2009).

4.3.10 Notification of adverse information

The Panel observes that there are no guidelines issued by the Reserve Bank which explicitly provide for the supervisor to ensure that banks notify the Reserve Bank as soon as they become aware of any material information which may negatively affect the fitness and propriety of a board member or a member of the senior management. At present this is being done on a voluntary basis.

The Panel recommends that the Reserve Bank issue specific guidelines in this regard that mandate banks to notify the Reserve Bank as soon as they become aware of any material information which may negatively affect the fitness and propriety of a Board member or a member of the senior management.

4.3.11 Appropriate skills in the back-office of the Bank Treasury

Though the Reserve Bank has issued guidelines periodically on the segregation of duties and responsibilities in the front office, mid-office and back office for treasury operations, it is not being determined whether there is an appropriate balance of skills and resources in back office and control functions relative to the front office. Though this aspect is looked into during the on-site inspection of banks, there is no specific mandate in the inspection manual in this regard.

The Panel recommends that the Reserve Bank issue appropriate guidelines to banks stressing the maintenance of such a balance by banks. It also recommends the incorporation in the inspection manual of a suitable provision mandating on-site inspectors to specifically comment on this aspect in their reports.

4.3.12 Risk-Based Supervision

The current supervisory mechanism consists of monitoring banks through on-site inspections and off-site returns obtained from them, and through periodic meetings with bank officials. The on-site supervisory mechanism adopted by the Reserve Bank is CAMELS (Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Systems and Control) approach for domestic banks and CALCS (Capital Adequacy, Asset Quality, Liquidity, Compliance and Systems and Control) for foreign banks. These banks are rated on the CAMELS/CALCS model based on the on-site inspection by the Reserve Bank. However, the CAMELS/CALCS rating does not clearly reflect the risk profile of the bank, and does not pinpoint the risks where the bank might be vulnerable or areas of risk where the bank has mitigating mechanisms to take care of the risks. Though a parallel run of Risk Based Supervision (RBS) is in progress for select banks, it is not yet mandated as a supervisory mechanism.

The Panel recommends a quicker adoption of the techniques and methodology of RBS. This will appropriately profile the bank, highlighting the risks and vulnerabilities it faces. Based on its assessment, the supervisory cycle for banks can then be determined. The Panel also recommends a further strengthening of off-site surveillance which is a pre-condition for the effective adoption of techniques and methodology of RBS.

4.3.13 Qualitative Disclosure

The Reserve Bank has issued detailed guidelines on accounting and disclosure norms and it is also satisfied that banks maintain adequate records drawn up in accordance with these accounting policies. However, though extant guidelines do require qualitative disclosure on risk management aspects, they are yet to be implemented.

The Panel recommends that there should be expeditious implementation of guidelines regarding qualitative disclosures, concurrent with full migration to Basel II. (The Panel notes that guidelines have since been issued mandating Indian banks with foreign operations and foreign banks to have formal Board approved disclosure policy from March 31, 2008 and for others from March 31, 2009).

4.3.14 Prompt Corrective Action

A concept Prompt Corrective Action (PCA) framework has been introduced by the Reserve Bank whereby it can initiate a set of actions against banks based on trigger points relating to the CRAR, Net NPA Ratio and Return on Assets. While the PCA framework has prescribed broad triggers, there is no specified timetable for initiating the mandatory actions and the discretionary actions.

The Panel feels that the guidelines on the PCA framework should provide for an appropriate timeline for initiating mandatory and discretionary actions to follow the identified triggers. If necessary, this could be finalised in consultation with the Government.

4.3.15 Consolidated Supervision

The Reserve Bank has issued a circular in February 2003 on consolidated accounting to facilitate consolidated supervision. Accordingly, banks that have subsidiaries are required to file consolidated financial statements and half-yearly consolidated prudential returns to the Reserve Bank. Though the Reserve Bank has the power to define the range of activities of the consolidated group, it does not have the power to cause inspections of any entity within the banking group which is not under its regulatory purview. The Panel recognises that the insertion of Section 29(A) (Power in respect of associated enterprise) in the Banking Regulation Act (Amendment) Bill 2005 would empower the Reserve Bank to conduct consolidated supervision. The Panel recommends expeditious passage of the Amendment Bill in Parliament.

4.3.16 Information sharing with Foreign Regulators

The RBI Act does not explicitly provide for the Reserve Bank to enter into any agreement with corresponding home/host supervisors. Consequently, there is no formal Memorandum of Understanding (MoU), and there is no agreed communication strategy between home/host regulators. Also the Banking Regulation Act empowers the Reserve Bank alone to inspect banks, and the overseas regulator is not permitted to inspect the Indian offices of the banks under their jurisdiction, share customer information (especially credit information) and inspection reports.

The Panel feels that there should be specific provisions in the RBI Act, 1934 and Banking Regulation Act, 1949 on lines of the SEBI Act, 1992 so that an MoU can be entered into with foreign supervisors establishing formal communication mechanisms. However, specifically empowering foreign entities to inspect domestic banks through amendment of an Act may not be feasible. There can be a clause in the MoU enabling the foreign regulators to inspect branches of foreign banks in India, subject to specific approval of the Reserve Bank and reciprocity.

Section 5

Urban Co-operative Banks

5.1 Legal Arrangements and Organisational set-up for Regulation and Supervision

Urban co-operative banks (UCBs) form an important part of Indian banking. They supply the credit requirements of the middle and lower middle classes and the marginalised sections in specific regions.

There is dual control of UCBs, inasmuch as the regulatory and supervisory responsibilities are shared between state registrars of co-operative societies (central registrar of co-operative societies in case of multi-state co-operative banks) and the Reserve Bank. The Registrars at the state-level exercise powers under the respective co-operative societies acts of the states in regard to incorporation, registration, management, amalgamation, reconstruction or liquidation. In case of urban co-operative banks with a multi-state presence, the central registrar of co­operative societies (CRCS) exercises such powers.

Banking related functions, such as the issue of license to start new banks / branches, matters relating to interest rates, loan policies, investments, prudential exposure norms, etc., are regulated and supervised by the Reserve Bank under the relevant provisions of the Banking Regulation Act, 1949 (as applicable to co-operative societies). While supervisory oversight of the Board for Financial Supervision (BFS) extends to UCBs, there is a multiplicity of command centres and an absence of clear-cut demarcation between the functions of State Governments and the Reserve Bank.

The “Vision Document for the UCB Sector” was formulated in March 2005 to address the issue of dual control within the existing legal framework. Inter alia, it provides for a two-track regulatory framework and a Memorandum of Understanding (MoU) between the Reserve Bank and the other regulators, viz., the State Governments and CRCS. The MoU is a working arrangement between the Reserve Bank and the State Government/CRCS to ensure that the difficulties caused by dual control are suitably addressed. The Reserve Bank has till date entered into MoUs with 24 states for supervisory and regulatory co-ordination.

5.2 Summary Assessment of Urban Co-operative Banks

Given the special features of UCBs in terms of their size and nature of their operations, some of the Basel Core Principles (BCPs) are not strictly applicable to them. These include:

i. Transfer of Significant Ownership (Principle 4): There is no concept of controlling/significant ownership of an UCB. Each member has only one vote irrespective of the number of shares held by him/her.

ii. Country and Transfer Risk (Principle 12): UCBs do not have exposure to foreign countries. Hence the question of country and transfer risk does not arise.

iii. Consolidated Supervision (Principle 24): UCBs do not belong to any banking group. UCBs registered in states do not have subsidiaries. Hence the concept of consolidated supervision is not applicable.

iv. Home-host Relationship (Principle 25): UCBs do not have foreign presence. Hence the question of a home-host relationship does not arise.

Also, the emphasis of other BCPs for UCBs may not carry equal significance vis-à-vis commercial banks.

The Panel recognises, therefore, that not all principles as encapsulated in the BCP are applicable to UCBs. BCPs are not applicable to a significant proportion of these entities which are very small in size and conduct only rudimentary banking operations. This assessment, therefore, has been conducted with respect to larger and scheduled UCBs with public deposits above Rs.100 crore in whose case many of the principles are applicable.

The summary assessment of adherence to 25 BCPs in respect of regulation and supervision of UCBs under the broad categories is provided in this chapter. The detailed principle-wise assessment is furnished in Appendix 5.

Box 3.8: International Co-operative Bank Models

Across the globe, there are three main co-operative banking models: (i) the ‘national’ co-operative bank model, (ii) the ‘federated’ co-operative bank model; and (iii) the ‘individual’ co-operative bank model.

The National Co-operative Bank Model

Two or more co-operatives banks/credit unions merge their assets into a federal co-operative bank with a single identity or brand. The merging entities are allocated membership of the post-merger single identity, and shares in proportion to their assets. However, each member gets only one vote and may have one director to the bank’s board. Profits and losses are allocated by the bank to the local co­operative banks/credit union members according to their number of shares. The co-operative bank is regulated as a single federal institution and produces consolidated financial statements.

The Federated Co-operative Bank Model

The federated structure in countries such as Netherlands (Rabobank Group), France (Credit Agricole Group), and Finland (OKO Group) lend financial strength to all the co-operative entities forming part of the structure. It revolves around a strong apex-level entity, which has even supervisory powers and responsibility. All the local co-operative banks are generally members of the apex entity. Each member exercises its voting rights under the one-member-one-vote principle. The apex bank supports and advises individual member banks in areas such as customer services, ALM, IT, mutual funds, product development, etc. A significant characteristic of European co-operative banks is the existence of a mutual support system. In several co-operative banking groups in Austria, France and the Netherlands, legally binding cross-guarantees are in place, whereby if any bank within the group faces financial trouble, other members of the group support it; in effect each has joint and several liabilities for each other’s commitments.

The Individual Co-operative Bank Model

Under this model, financial co-operatives function as individual co-operative banks with their own identities, brands, products, etc. UCBs in India come under this model. Such banks basically functions on a stand-alone basis. Financial co-operatives especially in Asia function under this model.

The co-operative models of some countries are furnished in Appendix 10.

5.2.1 Objectives, Autonomy and Resources (Principle 1)

All sub-components of the principle except for the one on independence, accountability and transparency, are fully compliant. The Reserve Bank along with RCS which regulates and supervises urban co-operative banks, has clear responsibilities and objectives and possesses transparent processes, sound governance and adequate resources. Although, by convention, the Reserve Bank is operationally independent and accountable de facto, the Central Government has powers to remove the head of the supervisory authority without specifying any reasons. It is only indirectly accountable to Parliament, through the executive wing of the Government of India. The transparency of the accountability framework needs closer introspection.

There is a suitable legal framework in place which includes provisions relating to the licensing of urban co-operative banks, setting prudential rules and their ongoing supervision (as per sections 21, 22 and 35 of the Banking Regulation Act (AACS), 1949). The legal framework empowers supervisors to address compliance with laws, to ensure safety and soundness of banks, to have access to banks’ boards, management, etc., and to take action against banks indulging in unsound practices. Legal protection is provided for supervisors (as per Section 54 of the Banking Regulation Act (AACS), 1949). There are both formal and informal arrangements for sharing information and co-operation between domestic regulators. As these entities do not have overseas presence, the question of sharing information with foreign regulators does not arise.

5.2.2 Licensing Criteria (Principle 2-3 and 5)

While the principles relating to major acquisitions are fully compliant, there remain some minor lacunae in respect of full compliance of permissible activities, licensing criteria and transfer of significant ownership. The activities that can be carried out by UCBs are clearly defined. Though the Banking Regulation Act (AACS), 1949, prohibits the use of the words ‘bank’, ‘banker’ or ‘banking’ other than by a co-operative bank as part of its name or in connection with its business, some primary credit societies (PCS), primary agriculture credit societies (PACS) and other entities call themselves banks and function as banks before a licence is granted by the Reserve Bank. The licensing criteria for banks which are consistent with ongoing supervision are laid down in Section 22 of the Banking Regulation Act (AACS), 1949. The Act provides for the automatic conversion of primary credit society with banking as one of its main activities to primary (urban) co-operative bank. Although they are required to apply to the Reserve Bank within three months of attaining capital plus reserves of Rs. 1 lakh for a licence under Section 22 of the Banking Regulation Act(AACS), 1949 , they can conduct banking business till the licence application is refused. This has led to the presence of a large number of unlicensed banks (79 as of January 1, 2008).

The Reserve Bank does not have control over the managerial affairs or shareholding which is vested with the RCS. There are no fit and proper criteria for directors, as per the Memorandum of Understanding (MoU) with the State Governments. But fit and proper criteria have been prescribed for chief executive officers of UCBs.

UCBs do not have cross border operations. Acquisition by way of merger requires the prior approval of both the regulators, viz., the Reserve Bank, and the registrar of co-operative societies/ central registrar of co-operative societies in case of multi-state UCBs.

5.2.3 Prudential Requirements and Risk Management (Principles 6-11, 13-18)

Of the 12 applicable principles relating to prudential requirements and risk management, three principles relating to capital adequacy, problem assets and related parties are compliant; three principles relating to credit risk, large exposure limits and abuse of financial services are largely compliant; four principles relating to risk management, market risk, liquidity risk and internal control are materially non-compliant and two principles relating to operational risk and interest rate risk in banking books are non-compliant.

The Reserve Bank has issued capital adequacy guidelines which include both on and off-balance sheet items which are uniformly applicable to all urban co-operative banks. At present, UCBs are Basel I compliant, other than in relation to the capital charge for market risk. However, capital charge has been provided for market risk through the surrogate method⁷.

The Reserve Bank has issued guidelines on risk management which are mostly confined to credit risk. The Asset Liability Management (ALM) guidelines regarding structural liquidity and interest rate risk are applicable only to scheduled UCBs, i.e., the larger entities. There is no system of confirmation by the supervisor regarding the adequacy of the risk management processes adopted by UCBs. The Reserve Bank does not determine whether the risk-taking function is segregated from the risk-evaluation/ monitoring/control function.

The existing credit risk guidelines issued by the Reserve Bank do not require that banks’ credit risk management policies/strategies should include the counterparty credit risk, except to certain sensitive sectors, arising through various financial instruments. The Reserve Bank has not issued any guidelines regarding potential future exposures (e.g., in forward contracts) and does not determine that UCBs have in place policies and processes to identify, measure, monitor and control counterparty credit risk exposures including potential future exposure. The Reserve Bank has issued detailed guidelines on income recognition, asset classification and provisioning. However, there is no effective mechanism for early identification of NPAs. The provisioning norms are not bank specific, but the supervisor has the power to prescribe these. The Reserve Bank has defined large exposure limits for banks. However, detailed risk management policies and practices to establish thresholds for acceptable concentration of credit are absent. The Reserve Bank has not issued detailed guidelines on market risk except for valuation norms for investments and asset-liability guidelines to scheduled UCBs.

The Reserve Bank has not issued detailed guidelines on liquidity risk except for ALM guidelines to scheduled UCBs. These guidelines do not take into account undrawn commitments and other off-balance sheet items. Though various guidelines for the prevention and reporting of frauds, internal/concurrent audit, balancing of books, etc., have been issued, the Reserve Bank has not issued detailed guidelines on identification, measurement and monitoring of operational risk to UCBs. It has also not issued any guidelines to banks for management of interest rate risk in banking book.

The Reserve Bank has issued guidelines to banks asking them to put in place adequate internal controls. A detailed evaluation of the internal audit function is, however, not undertaken. There is no system of reporting to the Reserve Bank of any adverse information on senior executives/members of the board. The Reserve Bank does not determine whether there is an appropriate balance in the skills and resources of the back office and control functions relative to the front office. The Reserve Bank has issued guidelines in respect of KYC norms and fraud monitoring. There is no legal protection available to whistle blowers.

⁷ The capital charge to market risk is being captured by assigning an additional risk weight of 2.5 per cent in respect of investments in addition to risk weights applicable for credit risk.

5.2.4 Methods of Ongoing Supervision (Principles 19 to 21)

The supervisory framework for urban co­operative banks is largely in place. All the three principles relating to methods of ongoing supervision are largely compliant.

The main instrument of supervision of UCBs is the periodic on-site inspection of banks supplemented by off-site monitoring and surveillance. No forward looking view of the risk profile of banks is taken by the supervisor. It does not evaluate the quality of the board/ management on an ongoing basis as part of its supervisory duties.

Under Section 27 of Banking Regulation Act (AACS), 1949, the Reserve Bank has the power to call for information from UCBs. However, auditors are not required to bring to the notice of the Reserve Bank any material shortcomings identified during the course of the work undertaken by them.

5.2.5 Accounting and Disclosure (Principle 22)

The aforesaid principle is largely compliant in case of UCBs. The formats for preparation of financial statements are prescribed under Section 29 of the Banking Regulation Act (AACS) 1949. But, the Reserve Bank has no access to audit reports and it does not meet auditors during its conduct of on-site inspection. Laws/ regulations do not require external auditors (not appointed for supervisory purpose) to report any significant adverse findings to the Reserve Bank.

5.2.6 Corrective Remedial Powers (Principle 23)

The aforesaid principle is largely compliant in case of UCBs. The Reserve Bank has at its disposal an adequate range of supervisory tools to bring about corrective action which includes the ability, where appropriate, to revoke the banking licence or recommend its revocation. While there is adequate corrective and remedial power vested in the Reserve Bank and RCS, dual control has led to slow supervisory response.

5.3 Recommendations

For the reasons stated above and given that even scheduled UCBs do not have any significant foreign presence at present - a position which is unlikely to change in a medium-term perspective-the Panel feels that migration to Basel II may not be feasible currently for the entire UCB sector.

In the opinion of the Panel, the single most important regulatory and supervisory hindrance that still exists in this sector is the problem of dual control.

5.3.1 Memorandum of Understanding

In order to mitigate regulatory disharmonies arising out of the system of dual control, MoUs have been entered into between the Reserve Bank, State Governments and the Central Registrar of Co-operative Societies. The Reserve Bank undertakes to constitute a state-level task force for urban co-operative banks with representatives from the Reserve Bank, State Governments and the sector for identification and drawing up of a time-bound action plan for the revival of potentially viable UCBs and the non-disruptive exit of non-viable UCBs and to facilitate human resources development and IT initiatives in UCBs. Till date, 24 State Governments and the Central Registrar of Co-operative Societies (CRCS) have entered into MoUs with the Reserve Bank.

The Panel is appreciative of the initiative and recommends that the Reserve Bank take immediate steps to sign MoUs with the remaining State Governments. At the same time, it also feels that while MoUs are appropriate from the medium-term perspective, in the interests of strengthening the sector, the regulatory and supervisory powers of UCBs should ultimately be vested with a single regulator which could be the Reserve Bank.

5.3.2 Capital Adequacy

The High-Powered Committee on UCBs constituted by the Reserve Bank in May 1999 observed that as UCBs perform the same banking functions as commercial banks and are exposed to similar risks in their operations, the non-application of capital adequacy norms to UCBs could undermine the stability of the whole banking system. Accordingly, based on the recommendations of the Committee, it was decided to make capital adequacy guidelines applicable to UCBs in a phased manner for scheduled and non-scheduled UCBs. So far, the capital adequacy norms for UCBs are as per Basel I norms, except for a capital charge for market risk. The capital charge for market risk in UCBs is in surrogate form where an additional 2.5 per cent risk weight is applied for market risk.

The Panel feels that it would be premature for the full migration of UCBs to Basel II norms at present. But given the increasing importance of interest rate risk in banks’ balance sheets, there is a need to assign a capital charge for market risk through the application of the Basel approach of quantifying ‘specific risk’ and duration-based ‘general risk’ for banks’ trading books at least for scheduled UCBs.

5.3.3 Risk Management

(i) The Reserve Bank does not review the system of corporate governance, risk management and internal control in UCBs.

The Panel recommends that the Reserve Bank needs to review the current system of corporate governance, risk management and internal control in place for UCBs and issue appropriate guidelines. If necessary, specific clauses could be inserted in the MoUs with State Governments.

(ii) Existing guidelines do not require UCBs to notify the Reserve Bank /registrar of co­operative societies as soon as they become aware of any material information which may negatively affect the fitness and propriety of any board member or member of the senior management.

The Panel recommends guidelines in this regard be issued.

5.3.4 Market Risk

Although, the Reserve Bank has powers under Section 35A of the Banking Regulation Act to impose specific limits and /or specific capital charges on market risk exposures on banks, no guidelines on market risk have been issued except for valuation norms for investments and ALM guidelines related to interest rate risk to scheduled UCBs. There are no guidelines on setting market risk limits commensurate with the size and complexity of the institution. No guidelines on stress testing, scenario analysis and contingency planning have been issued to UCBs.

The Panel recommends that the Reserve Bank issue guidelines on capital charges for market risk and usage of sensitivity and VaR limits as risk mitigation techniques to scheduled UCBs.

5.3.5 Liquidity Risk

Based on the recommendations of a Working Group constituted by the Reserve Bank, it was decided to make ALM guidelines on structural liquidity applicable to scheduled UCBs. However, these guidelines do not take into account undrawn commitments and other off-balance sheet items. Furthermore, UCBs do not have policies and processes in place for the ongoing measurement and monitoring of liquidity requirements.

The Panel recommends that the Reserve Bank needs to revise the ALM guidelines on structural liquidity issued to larger scheduled UCBs to take into account undrawn commitments and other off-balance sheet items. These entities should be also advised to adapt policies and processes for ongoing measurement and monitoring of liquidity risk.

The Panel also recommends that there is a need for extending the ALM guidelines to larger non-scheduled UCBs.

5.3.6 Operational Risk

The Reserve Bank has issued guidelines on the prevention and reporting of frauds, internal/ concurrent audit, balancing of books, etc. However, no guidelines have been issued on the operational risks to UCBs.

The Panel feels that given their size and the fact that they have not yet fully implemented Basel I, it would be premature to issue guidelines related to earmarking capital for operational risk based on the Basel II approach. However, basic guidelines on operational risk management can be considered to be issued to larger UCBs.

5.3.7 Interest rate risk in Banking Book

No specific guidelines have been prescribed for the management of interest rate risk in banking book.

The Panel feels that given their size and the fact that they have not yet fully implemented Basel I, it would be premature to issue guidelines on interest rate risk in banking book to these entities.

5.3.8 Balance of skills in the back and front offices of Treasury

The Reserve Bank does not determine whether there is an appropriate balance in skills and resources of the back office and control functions relative to the front office. It does not make an assessment of skills of employees of banks.

The Panel recommends that the Reserve Bank issue guidelines to the larger UCBs on the segregation of duties and responsibilities in the front office, mid office and back office for treasury operations related to scheduled UCBs.

Further, the Reserve Bank should make it necessary for its on-site inspection teams to look into this aspect in greater depth and comment about the same in their reports.

5.3.9 Notification to Regulator of Substantive Changes

There is no requirement for UCBs to notify the Reserve Bank of any substantive changes in their activities, structure and overall condition or as soon as they become aware of any material adverse developments.

The Panel recommends that the Reserve Bank issue guidelines in this regard.

5.3.10 Abuse of Financial Services

The Reserve Bank has issued detailed guidelines on Know-Your-Customer (KYC) to UCBs. However, there are no guidelines which give protection to bank staff who report suspicious activity in good faith either internally or directly to the relevant authority.

The Panel recommends that appropriate guidelines in this regard be issued.

5.3.11 Appointment of Auditors

Currently the Reserve Bank does not have the power to appoint external experts including auditors to conduct supervisory tasks. Auditors are not required to bring to the notice of the Reserve Bank any material shortcoming identified during the course of their work. Aspects relating to audit are attended to by RCS. As per MoUs signed between the Reserve Bank and RCS, the State Governments are required to provide for a statutory audit by chartered accountants appointed in consultation with the Reserve Bank, for UCBs with deposits of over Rs.25 crore. The Reserve Bank has entered into MoUs with 24 states and the Central Government till date.

The Panel urges the Reserve Bank to sign MoUs with the remaining State Governments. The Panel also recommends that the Reserve Bank in consultation with State Governments and ICAI explore the possibility of making it mandatory for external auditors to notify the Reserve Bank of any adverse developments that come to their notice during the course of their audit.

From a longer-term perspective, however, powers similar to those vested with the Reserve Bank under Section 30 of Banking Regulation Act, 1949, as applicable to commercial banks should form part of the MoU with State Governments, so as to alleviate the problems relating to auditors faced by the Reserve Bank (like appointment or removal of an auditor with the prior consent of the Reserve Bank, conducting a special audit of a bank if necessary in the interests of depositors, etc.)

5.3.12 Disclosures in Balance Sheet

As per existing guidelines, disclosures for UCBs in their balance sheets is limited to CRAR, investments, advances against real estate/ shares/debentures/ directors/ relatives, cost of deposits, NPAs, profitability indicators and provisions.

The Panel recommends an enhancement in the disclosure norms for UCBs, which could include quantitative disclosures regarding Tier I and II capital, non-SLR investments, exposure to the capital market (direct and indirect exposure), loans subject to restructuring for larger UCBs, etc. Furthermore, given the fact that some of the larger scheduled UCBs have made forays into derivatives, there could be additional disclosure requirements on the reporting of derivatives and ALMs for these entities.

Section 6

State Co-operative Banks and District Central Co-operative Banks

6.1 Legal Arrangement and Organisational set-up for Regulation and Supervision

The rural co-operative banking structure in India has two distinct structures: the short-term co-operative credit structure (STCCS) and the long term co-operative credit structure (LTCCS). The STCCS i.e., primary agricultural credit societies (PACS) at the village/base level, district central co-operative banks (DCCBs) at the intermediate level, and the state co-operative banks (StCBs) at the apex level, mostly provide crop and other working capital loans mainly for a short period to farmers and rural artisans. The long-term structure of rural co-operatives provide medium to long-term loans for investments in agriculture, rural industries and, of late, housing as well. Long-term co-operative credit institutions and PACS fall outside the ambit of the Banking Regulation Act, 1949, and so the Panel decided to cover as part of the assessment only StCBs and DCCBs. There are 31 StCBs (including 16 scheduled StCBs) of which 14 are licensed. Out of 366 DCCBs, 75 DCCBs are licensed as on 31 March 2007.

Like the urban co-operative sector, this sector is also subject to dual regulatory control. The Banking Regulation Act, 1949(AACS), provides the legal framework for regulation of these banks from the perspective of the Reserve Bank. The Reserve Bank exercises regulatory powers in relation to licensing, issue of directions and imposition of penalties, etc. The power of registering a co-operative society/bank, election and supersession of the board of directors, appointment of administrators, appointment/removal of the chief executive officer, winding up of a co-operative society, conduct of audit, etc., are vested with the RCS⁸. Supervisory power is vested with NABARD and these institutions are not within the supervisory oversight of Board for Financial Supervision (BFS) constituted by the Reserve Bank.

⁸ The recommendations of the Vaidyanathan Committee seek to minimsze the influence of the State Government in all such matters and it is expected that the recent Government of India package based on its recommendations, if implemented by the states; would solve these problems to a large extent.

There is, however, a Board of Supervision constituted independently by NABARD, which is kept abreast of the supervisory concerns that emanate from the functioning of rural co-operatives and other rural financial institutions. The board, in turn, provides direction on a continuing basis on regulatory policies and supervisory practices. While the supervisory function is carried out by NABARD, in the absence of powers to enforce satisfactory compliance by inspected banks on inspection observations, supervision is rendered less effective.

6.2 Summary Assessment of State Co­Operative Banks and District Central Co-operative Banks

Given the co-operative structure of StCBs and DCCBs and their scale of functioning, the Panel observes that the following principles as encapsulated in BCP are not applicable to StCBs/DCCBs:

i. Transfer of Significant Ownership (Principle 4): There is no concept of controlling/significant ownership of a StCB/DCCB. Each member has only one vote irrespective of the number of shares held by the member.

iii. Consolidated Supervision (Principle 24): StCBs/DCCBs do not have any subsidiaries in the sense in which commercial banks have subsidiaries/associates. Hence the concept of consolidated supervision is not applicable.

iv. Home-host Relationship (Principle 25): StCBs/DCCBs do not have a foreign presence. Hence the question of home-host relationship does not arise.

In spite of the non-applicability of some of the principles, the Panel feels that an assessment of the regulatory and supervisory structure of these entities would be useful for the following reasons:

i) StCBs and DCCBs taken together form the largest segment in the co-operative banking sector and account for almost 50 per cent of its total assets.

ii) These entities play a major role in credit delivery in the rural sector.

iii) These entities are ideal conduits for financial inclusion.

The Basel norms have not yet been made applicable to the StCBs and DCCBs. As a result, there is no stipulated risk-based capital requirement in respect of these entities.

In order to revive the short-term co­operative credit structure, a task force was set up by the Government of India under Prof. A. Vaidyanathan. The package suggested by it includes the signing of an MoU between NABARD, relevant State Government and the Government of India to reform the institutional structure, legal reforms and bring about a qualitative improvement in manpower. Capital augmentation of StCBs and DCCBs was a part of the package. The implementation of the Vaidyanathan Committee’s recommendations is underway. The assessment has been conducted keeping in view the ground realities in the rural financial sector and is less rigorous than the assessment made of commercial banks. The summary assessment of adherence to the BCPs in respect of regulation and supervision of StCBs/DCCBs under the broad categories is provided in this chapter. The detailed principle-wise assessment is furnished in Appendix 6.

6.2.1 Objectives, Autonomy and Resources (Principle 1)

All sub-components of the principle but for the one on independence, accountability and transparency are fully compliant. The responsibilities and objectives of the Reserve Bank and NABARD are clearly defined and both institutions possess sound governance practices and adequate resources to be accountable for the discharge of their duties. As per the existing statute, the Central Government is empowered to remove the head of the Reserve Bank without assigning any reason. Section 7(3) of NABARD Act, 1981, states that the Central Government may in consultation with the Reserve Bank remove the chairman at any time before the expiry of his term of office. Section 8(2) of NABARD Act, 1981 states that the Central Government may, in consultation with the Reserve Bank, remove the managing director or any whole-time director appointed under sub­Section (3) of section 6 any time before the expiry of his term of office, after giving him reasonable opportunity to show cause against the proposed removal. The Act is silent about the public disclosure of reasons for the removal of the head of the supervisory authority.

There is a suitable legal framework in place which includes provisions relating to the licensing of StCBs/DCCBs, the setting of prudential rules and their supervision. The extant legislation empowers NABARD to assess compliance with laws, to ensure the safety and soundness of banks, to have access to banks’ boards, management, etc., and to take action against banks indulging in unsound practices. Legal protection is available for supervisors. Arrangements for the sharing of information between supervisors and protecting the confidentiality of such information are also in place.

6.2.2 Licensing Criteria (Principles-2, 3 and 5)

While the principles relating to major acquisitions are fully compliant, there remain some gaps in respect of full compliance of permissible activities and licensing criteria. Section 6(1) of the Banking Regulation Act, 1949 (AACS) indicates the list of permissible activities that can be taken up by a banking company. However, the word “bank” can be legally used by unlicensed and unsupervised entities, e.g., PACS, state co-operative agriculture and rural development banks (SCARDBs) and primary co­operative agriculture and rural development banks (PCARDBs) which are outside the ambit of the Banking Regulation Act, 1949 (AACS). Though the Reserve Bank has set the criteria for granting licences for setting up of StCBs/ DCCBs and has the power to reject applications which do not meet the standards based on the recommendations of NABARD, it does not have the power to determine the suitability of shareholders. The RCS can disqualify directors. The ability of shareholders to provide additional financial support also cannot be assessed. The acquisition of co-operative banks is allowed only by way of mergers/amalgamation, with the specific permission of the regulators. Co­operative banks do not have cross-border operations.

6.2.3 Prudential Requirements and Risk Management (Principles 6 to 11 and 13 to 18)

The Basel norms have not been made applicable to StCBs and DCCBs. Broad guidelines on risk management have been issued to StCBs/DCCBs. Of the 12 principles relating to prudential requirements and risk management, only two principles relating to large exposures and related parties are compliant; two principles relating to credit risk and problem assets, provisions and others are largely compliant; six principles relating to capital adequacy, risk management, market risk, liquidity risk, internal control and abuse of financial services are materially non-compliant; and two principles relating to operational risk and interest rate risk in banking book are non-compliant.

No risk-based capital adequacy guidelines to StCBs and DCCBs have been issued. The Reserve Bank has recently advised all co­operative banks to indicate the CRAR in their balance sheets as on 31 March 2008 and thereafter every year, as ‘Notes on Accounts’ to their balance sheets.

At present, risk management aspects are being reviewed by the boards of StCBs and DCCBs, based on the data placed before them on credit risk, liquidity risk and interest rate risk. Asset Liability Management (ALM) guidelines have been issued to five StCBs on a pilot basis. Sophisticated techniques of integrated risk management are not considered necessary for StCBs/DCCBs in view of the small size and volume of their operations.

Guidelines have been issued covering all the essential aspects required for the setting up of credit management measures in StCBs and DCCBs. Guidelines have also been issued to StCBs and DCCBs on income recognition, asset classification and provisioning, covering both on and off-balance sheet exposures. NABARD/ the Reserve Bank has prescribed regulatory limits on banks’ exposure to individual and group borrowers to avoid concentration of credit, and has advised these banks to fix limits on their exposure to specific industries or sectors for ensuring better risk management. The concept of ‘related party’ is not strictly applicable to StCBs and DCCBs as there is no promoter holding a substantial shareholding as in the case of commercial banks. As per extant provisions of the Banking Regulation Act, banks are prohibited to grant loans and advances (other than for personal use) to any of its directors or their related parties.

NABARD/the Reserve Bank has not prescribed any guidelines for assessing market risk by StCBs and DCCBs except for valuation norms for investment. Since 1 April, 2007, Asset-Liabilities Management (ALM) has been introduced in five select StCBs on a pilot basis. No specific guidelines on the management of liquidity risk, operational risk and interest rate risk in banking books have been issued to StCBs and DCCBs.

Guidelines on various aspects of internal checks and control systems in co-operative banks have been issued. NABARD/ the Reserve Bank does not have any power to bring about changes in the composition of the board and senior management to address any prudential concerns. However, under the MoU signed by states for implementation of the Vaidyanathan Committee’s recommendations, ‘fit and proper criteria’ for directors of the board and CEOs of banks are to be prescribed by the Reserve Bank. Further, as per the MoU, directors/CEO not fulfilling the ‘fit and proper criteria’ stipulated by the Reserve Bank can be removed at the request of the Reserve Bank /NABARD.

The Reserve Bank has issued KYC guidelines to StCBs and DCCBs wherein they have been advised to follow due procedure, including reporting of cash transactions to the Financial Intelligence Unit. The system to designate a compliance officer has not yet been made operational. NABARD/ the Reserve Bank do not have any authority to address criminal activities. Protection to whistle blowers is not legally available.

6.2.4 Methods of Ongoing Supervision (Principles 19-21)

The supervisory framework for StCBs and DCCBs is largely in place. All the three principles relating to methods of ongoing supervision viz., supervisory approach, supervisory techniques and supervisory reporting are largely compliant.

NABARD employs a mix of on-site and off-site supervision to evaluate the condition of StCBs and DCCBs, their inherent risks, and the corrective measures necessary to address supervisory concerns and to supplement it with periodic discussions with the management. There is no requirement for StCBs and DCCBs to notify NABARD/ the Reserve Bank of any substantive changes in their activities, structure and overall condition, or as soon as they become aware of any material adverse developments. Supervisory work is not prioritised based on the risk profile.

NABARD has continuous interactions with the banks’ boards/CEOs for understanding their risk perception, risk management systems and the risk mitigation measures in place. Under Section 27(2) of the Banking Regulation Act, 1949 (AACS), NABARD has powers to call for any information from a banking company relating to its affairs.

6.2.5 Accounting and Disclosure (Principle 22)

The aforesaid principle is largely compliant. NABARD can take recourse to the provisions of the Banking Regulation Act, 1949 (AACS) for initiating action against StCBs and DCCBs which furnish wrong/incorrect information. All the financial statements published by StCBs and DCCBs are verified by co-operative auditors/ chartered accountants. The scope of external audits of individual banks and the standards to be followed in performing such audits is under the purview of the RCS. In the 25 states which have signed MoUs till December 2008, the States will have to make provisions in their state co-operative societies Acts for auditing of StCBs/DCCBs by chartered accountants approved by NABARD. In non-MoU states no such clause is there.

6.2.6 Corrective Remedial Powers (Principle 23)

The aforesaid principle is largely compliant. NABARD has framed a trigger point policy in consultation with the Reserve Bank in terms of which it recommends regulatory action to the Reserve Bank against those banks which fail to achieve a certain level of performance. However, the powers of corrective actions are vested with the Reserve Bank, and NABARD can play only a recommendatory role. The Reserve Bank also does not enjoy powers similar to Section 36AA of the Banking Regulation Act, 1949, to remove managerial and other persons from holding office in co-operative banks.

6.3 Recommendations

In the opinion of the Panel, the single most important regulatory and supervisory hindrance that still exists in this sector is the problem of dual control by the RCS and the Reserve Bank /NABARD. Given the inadequate financial soundness of StCBs and DCCBs, the Panel feels that it would be premature to prescribe Basel norms for these entities before the revival package as recommended by the Vaidyanathan Committee is fully implemented. It is with this view that the Panel has assessed the adherence of StCBs/DCCBs to Basel Core Principles and observed some regulatory and supervisory gaps. The Panel has also made recommendations which, if implemented, could ensure better compliance to Basel Core Principles and strengthen the regulation and supervision of StCBs and DCCBs.

6.3.1 Memorandum of Understanding

In order to circumvent the regulatory disharmonies arising out of dual control of StCBs and DCCBs, MoUs have been entered into between NABARD, State Governments and the Central Registrar of Co-operative Societies. The Central Government has set up a National Implementing and Monitoring Committee under the Chairmanship of the Reserve Bank Governor to oversee the implementation and monitoring of the revival package for StCBs and DCCBs. Till December 2008, a total of 25 State Governments and the Central Registrar of Co­operative Societies have entered into MoUs with NABARD.

The Panel observed that NABARD has been discharging duties of supervision of StCBs and DCCBs, while the Reserve Bank has been regulating these entities. The Panel recommends that NABARD take steps to sign MoUs with the remaining State Governments. At the same time, it also feels that while MoUs are appropriate from the medium-term perspective, in the interest of strengthening the sector, the regulatory powers in respect of StCBs/ DCCBs should be divested from the government and ultimately vest with a single regulator.

6.3.2 Capital Adequacy

There is no concept of risk-based capital adequacy at present for StCBs/DCCBs.

The Panel observed that though these entities have adopted the concept of minimum capital requirements, it is not risk-based capital requirement. It recommends that, as suggested by the Vaidyanathan Committee, risk-based capital requirements of 7 per cent may be introduced for StCBs/DCCBs and increased in a phased manner to 9 per cent which is the stipulated minimum in case of commercial banks.

6.3.3 Risk Management

The Reserve Bank /NABARD have not issued guidelines on risk management to StCBs/ DCCBs along the lines of commercial banks. There are no guidelines on market risk, liquidity risk, operational risk and interest rate risk in banking books.

The Panel recommends that once the concept of risk-based capital adequacy is introduced for StCBs/DCCBs, the issuance of guidelines on risk management along the lines of UCBs should be considered. It also recommends that some basic guidelines regarding management of market risk, operational risk and liquidity risk be stipulated. There is, however, no requirement for stipulating any capital charge for market risk, and operational risk. It is also premature to consider measurement and capital augmentation to mitigate interest rate risk in banking book.

6.3.4 Notification to Regulator of Substantive Changes

There is no requirement for StCBs/DCCBs to notify the Reserve Bank /NABARD of any substantive changes in their activities, structure and overall condition or as soon as they become aware of any material adverse developments.

The Panel recommends that the Reserve Bank /NABARD issue requisite guidelines in this regard.

6.3.5 Abuse of Financial Services

The Reserve Bank has issued detailed guidelines on Know-Your-Customer to StCBs and DCCBs. However, there are no guidelines which give protection to bank staff who report suspicious activity either internally or directly to the relevant authority.

The Panel recommends that appropriate guidelines be issued in this regard.

6.3.6 Appointment of Auditors

Currently the Reserve Bank /NABARD do not have any power to appoint external experts including auditors to conduct supervisory tasks. Further, auditors auditing the accounts of StCBs and DCCBs are not required to bring to the notice of the Reserve Bank /NABARD any material shortcomings. Aspects relating to audits are attended to by RCS. As per the MoUs signed between the Reserve Bank /NABARD and RCS, the State Governments are required to provide for a statutory audit by chartered accountants appointed in consultation with the Reserve Bank /NABARD for StCBs/DCCBs with deposits over Rs.25 crore. They are also required to provide for a special audit by chartered accountants, if required by the Reserve Bank /NABARD, for any StCB/DCCB. The Reserve Bank /NABARD have entered into MoUs with 25 states and the Central Government till December 2008.

The Panel strongly recommends that the Reserve Bank /NABARD in consultation with State Governments and ICAI explore the possibility of making it mandatory for external auditors to notify any adverse developments that have come to their notice during the course of their audit to the Reserve Bank /NABARD. From a longer-term perspective, however, powers similar to those vested with the Reserve Bank under Section 30 of the BR Act as applicable to commercial banks⁹ should form part of the MoUs signed with State Governments so as to alleviate problems relating to audit functions faced by the Reserve Bank /NABARD.

Section 7

Regional Rural Banks

7.1 Legal arrangement and Organisational set-up for Regulation and Supervision

Regional Rural Banks (RRBs) are a special category of banks formed by notification by the Government of India under Section 3(a) (1) of the Regional Rural Banks (RRBs) Act, 1976. Section 6(2) of the RRBs Act, 1976, prescribes the ownership criteria for RRBs. The authorised capital of each RRB is Rs. 5 crore, which can be increased or reduced by the Central Government. However, the issued capital shall in no case be less than Rs.25 lakh. The capital issued by RRB is subscribed by the Central Government (50 per cent), the State Government (15 per cent) and a sponsor bank (35 per cent) which is generally a public sector commercial bank (with the exceptions of the Bank of Rajasthan, Jammu and Kashmir Bank and Uttar Pradesh State Co-operative Bank). In addition to the RRB Act of 1976, RRBs are governed by the Banking Regulation Act, 1949 and RBI Act, 1934.

RRBs’ operations are limited to an area notified by the Central Government in the official gazette. While these entities may transact business of banking as defined in clause (b) of Section 5 of the Banking Regulation Act 1949, vide Chapter IV, Section 18 of the RRB Act 1976, they may, in particular undertake the following kinds of business:

• Granting of loans and advances particularly to small and marginal farmers and agricultural labourers; and

• Granting of loans and advances to artisans, small entrepreneurs and persons of small means engaged in trade, commerce or industry or other productive activities in the notified area.

Currently, RRBs are not required to be Basel I compliant. There is no stipulation for risk-based capital adequacy norms for these entities. These entities also do not have any international operations as their activities are limited in the notified area.

⁹ Such as appointment or removal of a auditor with the prior consent of RBI/NABARD, carry out a special audit of a bank if necessary in the interest of depositors, etc.

The regulation of RRBs is undertaken by the Reserve Bank. The supervision of RRBs is conducted by NABARD. RRBs are within the supervisory oversight of Board of Supervision constituted by NABARD. Powers to close/ amalgamate/merge RRBs rest with the Central Government.

7.2 Summary Assessment of Regional Rural Banks

Given the special features of RRBs, some of the Basel Core Principles are not strictly applicable to them. viz.,

i. Licensing Criteria (Principle 3): The licensing authority for RRBs is the Government of India as they are licensed banks ab initio. The RRBs do not require a licence for their establishment under Section 22 of the Banking Regulation Act, 1949, and the Reserve Bank cannot withdraw it. However, RRBs have to apply for a licence to the Reserve Bank for opening branches. The Reserve Bank / NABARD does not have any power to reject the licence of an RRB since the powers to close/ amalgamate/ merge RRBs vest with the Government of India as per provision of Section 23 A(1) and Section 26 of the RRB Act, 1976.

ii. Transfer of Significant Ownership (Principle 4): There is no concept of controlling/significant ownership for RRBs as the capital issued by an RRB is subscribed by the Central Government (50 per cent), concerned State Government (15 per cent) and sponsor bank (35 per cent).

iii. Country and Transfer Risk (Principle 12): As RRBs do not have exposure to foreign countries, exposures to country and transfer risks do not arise.

iv. Consolidated Supervision (Principle 24): RRBs do not have subsidiaries. Hence the concept of consolidated supervision is not applicable.

v. Home-host Relationship (Principle 25): RRBs do not have foreign presence. Hence the concept of a home-host relationship does not arise.

The Panel recognises therefore that not all principles as delineated in BCP are applicable to RRBs. Also, as risk based capital stipulation is yet to be mandated for RRBs, the emphasis of other BCPs for RRBs may not carry equal significance vis-à-vis commercial banks. The summary assessment of adherence to BCPs as applicable in respect of regulation and supervision of RRBs under the broad categories is provided in this chapter. The detailed principle-wise assessment is furnished in Appendix 7.

7.2.1 Objectives, Autonomy and Resources (Principle 1)

All sub-components of the principle but for the one on independence, accountability and transparency are fully compliant. The Reserve Bank, along with NABARD, regulates and supervises RRBs. Both have clear responsibilities and objectives and possess transparent processes, sound governance practices and adequate resources. Conventionally, even though the Reserve Bank is operationally independent, the Central Government is empowered to remove the head of the Reserve Bank without assigning any reason. Similarly, the Central Government can, in consultation with the Reserve Bank, remove the NABARD Chairman or other directors at any time before the expiry of their term of office without the disclosure of reasons.

There is a suitable legal framework in place which includes provisions relating to setting prudential rules and ongoing supervision. Laws are in place for banking supervision which empower NABARD to address compliance with laws, to ensure safety and soundness of banks, to have access to banks’ boards, management, etc., and to take action against banks indulging in unsound practices. Legal protection for supervisors is also available. There are formal and informal arrangements in place between the Reserve Bank and NABARD for co-operation and sharing of information pertaining to RRBs.

7.2.2 Licensing Criteria (Principles 2 and 5)

Both applicable principles, the one relating to permissible activities and other relating to major acquisitions are fully compliant. Section 5(b) of the Banking Regulation Act, 1949, defines “banking” clearly. The permissible activities of institutions that are licensed and subject to supervision are clearly defined. NABARD/ the Reserve Bank has specified the areas of investments that can be undertaken by RRBs. They are not permitted to enter into cross-border operations. There are no cases of acquisitions by RRBs, other than amalgamations approved by the Government of India, as of now.

7.2.3 Prudential Requirements and Risk Management (Principles - 6 to 11 and 13 to 18)

There is no concept of risk-based capital adequacy for RRBs and the risk management systems of RRBs are rudimentary. As RRBs are not required to be Basel I compliant, this assessment has been made keeping in view the current status. Of the 12 principles relating to prudential requirements and risk management, only two principles relating to credit risk and problem assets, provisions and others are compliant; two principles relating to large exposures and related parties are largely compliant; six principles relating to risk management, market risk, liquidity risk, operational risk, internal control and abuse of financial services are materially non-compliant and two principles relating to capital adequacy and interest rate risk in banking book are non-compliant.

Broad guidelines on Risk Management Systems for RRBs were issued in 2004. Given their scale of operations the introduction of an Integrated Risk Management approach at present is not feasible because it entails huge investments in computerisation for the collection of necessary data. There is no stipulated capital charge for credit risk. NABARD determines, and periodically confirms, that senior management implements the credit risk strategy approved by the board. Guidelines to RRBs on income recognition, assets classification and provisioning have been issued. There are no specific guidelines in respect of management of market and interest rate risk in the banking books. Currently, most RRBs assess their liquidity positions, covering both on and off-balance sheet items without adopting the Asset Liability Management (ALM) methodology. ALM guidelines have been issued to begin with to 12 RRBs with effect from April 1, 2007. Illustrative guidelines on operational risk have been issued to RRBs.

Given the limited scope available in their area of operations, the exposure of RRBs to group borrowers is limited. The exposure of an RRB to a company cannot exceed 15 per cent of its owned funds. Sectoral exposures are not monitored by NABARD.

The RRB Act, 1976 clearly provides for duties and responsibilities of the Board, top management, etc., which are scrupulously followed by RRBs. Internal control measures are left to the individual management. However, uniform internal checks and control system manual for all RRBs have not been introduced. Though KYC guidelines have been issued, no whistle-blower policy is in place. NABARD has issued guidelines on the compliance function for RRBs including appointing a designated compliance officer.

7.2.4 Methods of Ongoing Supervision (Principles 19-21)

The supervisory framework for RRBs is largely in place. All the three principles relating to methods of ongoing supervision viz., supervisory techniques, supervisory approach and supervisory reporting are largely compliant.

NABARD monitors RRBs through on-site inspections and off-site surveillance returns. It also has a system of collecting data by way of statistical and other returns from time to time from RRBs.

7.2.5 Accounting and Disclosure (Principle 22)

The aforesaid principle is largely compliant. Guidelines on accounting standards have been issued to RRBs. They have been granted an exemption, till March 31, 2008, relating to the publication of their balance sheets, profit and loss accounts and auditors’ reports. Further, RRBs have been advised to display their balance sheet and profit and loss accounts in all their branches.

7.2.6 Corrective and Remedial powers (Principle 23)

The aforesaid principle is largely compliant. NABARD participates in deciding when and how to effect orderly resolution in case of a problem bank. It has at its disposal a range of supervisory tools for use when in its judgement, a bank is not complying with laws, regulations or supervisory decisions, or is engaged in unsafe or unsound practices, or when the interests of depositors are otherwise threatened. NABARD has various instruments, processes and systems to bring about various timely corrections in respect of RRBs failing to come up to expected level of operational and financial efficiencies. It seeks to intervene at an early stage to prevent capital from falling below the minimum and has a range of options to address such scenarios. It applies penalties and sanctions not only to the bank but, when and if necessary, also to the management and/ or the board, or individuals therein.

7.3 Recommendations

In the light of the gaps observed in its assessment of adherence to the Basel Core Principles in respect to regulation of Regional Rural Banks (RRBs), the Panel has made the following recommendations to strengthen the regulation and supervision of these entities.

7.3.1 Capital Adequacy

Risk-based capital adequacy norms have not so far been made applicable to RRBs. The minimum capital requirement in absolute terms has been spelt out in the RRBs Act, 1976.

The Panel recommends introduction of minimum CRAR along with the recapitalisation of RRBs in a phased manner, after completion of a consolidation process of these entities.

7.3.2 Risk Management Process

RRBs have put in place risk management systems, but these do not cover all types of risks. The existing risk management guidelines cover broadly only the credit and liquidity risks. No specific guidelines have been issued in respect of operational risk and market risk to RRBs. They have not been permitted to use internal risk assessment models by NABARD. The concept of integrated risk management is also not recognised in the case of RRBs.

The Panel feels that once capital adequacy norms are made applicable to RRBs, guidelines on risk management related to market and operational risks should be introduced.

However, given the limited and rudimentary scale of operations of RRBs, capital charge for market risk and operational risk need not be mandated for some time. The Panel has come to the conclusion that while the current data base of RRBs is not adequate for a sophisticated assessment of risk, the collection of required on-line data from branches would call for state-of-the-art technological upgradation and would involve huge investments, which the RRBs may not be in a position to meet. Sophisticated techniques like internal risk assessment models and integrated risk management are not considered necessary at this stage, in view of size, volume and nature of business operations of RRBs.

7.3.3 Large Exposure Limits

NABARD does not obtain information regularly that enables it to review the concentrations, including sectoral and geographical exposures, within a bank’s portfolio.

The Panel observed that most lending by RRBs are under the priority sector segment and they have very limited exposure to other segments, both under lending and investments. Moreover, these exposures are reviewed at the time of on-site inspection with a broad-based approach to ascertain the sectoral and segment-wise credit disbursed by the banks. Hence, the Panel does not recommend calling for sectoral and geographical exposures from RRBs at present.

7.3.4 Market Risk, Liquidity risk and Operational Risk

No guidelines have been prescribed for assessing market risk by RRBs. RRBs follow a methodology for assessing their liquidity position, but not on an ALM basis. ALM has been introduced in only 12 RRBs with effect from April 1, 2007. NABARD has been examining these aspects during the course of on-site inspections. Broad guidelines on all types of risks, as to identifying credit, market, interest rate and operational risks, and how they can be mitigated, have been issued to RRBs.

The Panel feels that given the fact that RRBs are currently in a non-Basel regime, the assessment of market risk can be implemented only after CRAR is introduced. This is envisaged along with the recapitalisation of RRBs. As commercial banks are stakeholders in RRBs, the Panel feels that it would be easier to implement some of the guidelines issued by them on liquidity risk and operational risk.

Accordingly, the Panel recommends that as regards assessment of operational risk, guidelines on the lines applicable to commercial banks can be issued to RRBs. As regards liquidity risk, the Panel recommends that the concept of Asset Liability Management (ALM) be introduced for all RRBs along the lines for commercial banks. However, stipulating capital charges for such risks will be premature at this stage.

7.3.5 Interest Rate Risk in Banking Book

No guidelines on interest rate risk in banking books have been issued to RRBs.

The concept of interest rate risk in banking books is part of the Basel II Accord. Since RRBs are yet to migrate to Basel I mode, the introduction of interest rate risk in banking would mean placing a significant burden on these entities. The Panel recommends that the concept of interest rate risk in banking books may not be considered for these entities at least over the medium-term.

7.3.6 Internal control and Audit

(i) The Reserve Bank /NABARD do not have the power to require changes in the composition of the board and senior management of RRBs to address prudential concerns.

Since the composition of the board of RRBs is in accordance with the provisions of the RRBs Act, 1976, wherein nomination to the board is made with due approval from the Government of India (GoI), any change in this regard would require an amendment to the Act. However, the Panel feels that there is no need for any change at the current juncture.

(ii) Corporate governance in the strictest sense of the term has not so far been made applicable to RRBs as board members are generally nominated directors and not independent directors. Nor have they have been made accountable for all omissions and commissions.

The Panel observes that though directors are nominated to RRBs, it would be desirable to make them accountable. There should be a formal Board-approved policy in this regard. Further, it feels that over the medium-term, the Government could consider independent nominees on the boards of these banks.

(iii) While NABARD has issued guidelines regarding separation of functions in respect of the back office and front office, it does not determine whether there is an appropriate balance in the skills and resources of the back office and control functions relative to the front office/business origination.

The Panel recommends that NABARD may comment on this aspect during the on-site examination of RRBs.

(iv) NABARD is in the process of preparing suitable guidelines on the ‘Compliance Function’ for RRBs in consultation with the Reserve Bank, on the lines of instructions issued to commercial banks. So far, NABARD has put in place a compliance system envisaging the submission of core compliance, full compliance, discussion on core compliance and rating of the compliance report with reference to observations made in the inspection report. Based on the nature of functions and size of RRBs, it has not been considered necessary to have a separate compliance function cell with them.

¹⁰ Licensing is interpreted as grant of Certificate of Registration

There are regulatory norms for the management of problem assets of provisions and reserves. But there is no provisioning requirement for standard assets. Prudential limits to restrict exposures of NBFCs to single counterparties (or groups of connected parties) are in place. However, the Reserve Bank has not issued any instructions as regards the review and reporting of material concentration to the Board. Sectoral, geographical and currency exposures of NBFCs are not monitored.

Exposure to related counterparty is dealt with under Section 295 of the Companies Act, 1956. The Reserve Bank has issued ALM guidelines to a certain class of NBFCs¹¹ on an asset liability framework which includes the constitution of an Asset-Liability Committee (ALCO) and measuring future cash flows of NBFCs in different time buckets for the purpose of managing their liquidity and interest rate risk. However, the Reserve Bank has not issued guidelines for earmarking capital for operational risk to NBFCs. There is no bifurcation into trading book and banking book in the case of NBFCs.

The Reserve Bank has issued guidelines to NBFCs to put in place adequate internal controls. But it has not issued any directions assigning the responsibility for the control environment to the board and senior management of NBFCs. Furthermore, the Reserve Bank is not empowered to bring about changes in the composition of the Board and the senior management to address prudential concerns. The Reserve Bank does not determine whether there is an appropriate balance in the skills and resources of the back office and control functions relative to the front office/business origination.

Guidelines on KYC norms have been issued to NBFCs, but, the Reserve Bank has not put in place any due diligence policies. However, while granting permission for setting up a liaison office in India by a foreign NBFC, their operations from tax haven countries is accorded due cognizance.

There is no procedure for confirmation by the supervisor of money laundering prevention, the identification and the reporting of potential abuses. There is no mechanism to ensure compliance with KYC guidelines by non-deposit taking companies which are not inspected or subject to reporting exercise. There are no laws in place which give protection to NBFC staff who report suspicious activity in good faith either internally or directly to a relevant authority.

8.2.4 Methods of Ongoing Supervision (Principles 19 to 21)

There is a supervisory framework in place for NBFCs. All the three principles relating to methods of ongoing supervision, viz., supervisory approach, supervisory techniques and supervisory reporting are largely compliant.

As regards the supervisory approach, a certain class of NBFCs has been advised to put in place a risk management committee to assess the risk it faces. Any change in the structures or failure to comply with prudential norms or any other prescriptions is to be reported by statutory auditors through an exception report to the Reserve Bank. The system is yet to stabilise.

¹¹ NBFCs having Rs.20 crore deposits or Rs.100 crore assets

The Reserve Bank conducts both on-site (Section 45N of RBI Act) and off-site supervision (Section 45K and L of RBI Act) for the supervision of NBFCs. This supervision is limited to NBFCs-D and NBFCs-ND-SI. No interaction takes place with the senior management.

As part of the supervisory reporting mechanism, the Reserve Bank has been empowered under Section 45K and 45L of the RBI Act, 1934, to collect information from NBFCs and to issue directions. Under Section 45M of the RBI Act, 1934 it is the duty of every non-banking institution to furnish statements, information or particulars called for by the Reserve Bank.

8.2.5 Accounting and Disclosure (Principle 22)

The aforesaid principle is largely compliant. As regards accounting and disclosure, the Reserve Bank ensures that each NBFC maintains adequate records drawn up in accordance with accounting policies and practices that are widely acceptable and publishes on a regular basis information that fairly reflects its financial condition and profitability. The Reserve Bank has no power to reject and rescind the appointment of an external auditor that is deemed to have inadequate expertise or independence, or is not subject to or does not follow established professional standards.

8.2.6 Corrective and Remedial Powers (Principle 23)

The aforesaid principle is largely compliant. The Reserve Bank has at its disposal an adequate range of supervisory tools to bring about timely corrective actions which includes the ability to revoke the Certificate of Registration. There is no prompt corrective action framework stipulated for NBFCs other than in cases where it has been specified at the time of granting of registration that such approval is required before undertaking the activity. The Reserve Bank does not have powers to withhold approval of new activities, other than while specifying at the time of granting registration, or acquisitions. It also is not empowered to restrict or suspend payments to shareholders or share repurchases, restrict asset transfers, bar individuals from operations, replace or restrict the powers of managers, board directors or controlling owners, facilitate a takeover or merger with a healthier institution, or provide for the interim management of the NBFC.

8.2.7 Consolidated Supervision and Cross-border Banking (Principles 24 and 25)

Both the principles relating to consolidated supervision and cross-border banking are non-compliant. As regards consolidated supervision, the Reserve Bank has no power to establish prudential standards on a consolidated basis to cover such areas as capital adequacy, large exposures, exposures to related parties and lending limits. It collects financial information for a group identified as a ‘financial conglomerate’.

Of late, it has been observed that foreign entities have evinced interest in the NBFC sector. Policy initiatives have been taken to recognise the role of home-host regulators in this regard. Draft guidelines for a No-objection Certificate for opening of branches / joint venture abroad by NBFCs have been placed on the Reserve Bank website for comments / suggestions from public/stakeholders.

8.3 Recommendations

The Panel observed that the NBFC sector is less closely regulated and supervised than the banks, and that not all Basel Core Principles (BCPs) can be made applicable to the sector because many of these entities are very small in size and do not conduct banking operations in the strict sense. Given that the Reserve Bank has not fully stipulated Basel norms for this sector and given that these entities cannot accept demand deposits, the Panel feels that migration to Basel II may not be feasible currently for these entities.

However, the key area of concern is the increasing interest shown by foreign NBFCs in entering the country, raising a host of issues relating to mitigation of risks emanating from global exposure, information-sharing between home-host regulators, proper due diligence norms, etc., for which adequate guidelines are not in place. Apart from the above, the Panel has observed some regulatory and supervisory gaps while assessing the adherence to Basel Core Principles (BCPs) in regulation and supervision of NBFCs. The Panel has made appropriate recommendations which, if implemented, could strengthen the regulation and supervision of NBFCs. The recommendations are detailed below:

8.3.1 Sharing of Information with Domestic and Foreign Regulators

Of late, foreign entities have evinced growing interest in the NBFC sector. Also some domestic NBFCs are exploring global business opportunities. There are no formal arrangements in place for co-operation and information sharing with foreign financial sector supervisors of NBFCs.

The Panel recommends a formalisation of the relationship with foreign regulators. It should encapsulate a transparent method of information sharing. There should be specific provisions in the RBI Act, 1934 along the lines of the SEBI Act, 1992, so that MoUs can be entered into with foreign supervisors for establishing a formal communication mechanism for NBFCs.

The Panel acknowledges that policy initiatives have been taken to recognise the role of co-operation between home-host regulators. But no guidelines have yet been issued. The Panel recommends that the Reserve Bank expedite issuing guidelines in this regard.

8.3.2 Composition of the Board

At present, the suitability of major shareholders and senior management is not subjected to detailed scrutiny. Due diligence is done only in respect of the directors.

The Panel recommends that the Reserve Bank needs to explore the option of examining the suitability of major shareholders and senior management of NBFCs.

8.3.3 Ownership Issues

(i) The RBI Act does not delegate any powers under the Act to empower the Reserve Bank to bring about changes in the composition of the boards and senior management of NBFCs to address prudential concerns.

The Panel feels that the Reserve Bank should explore the option of acquiring legal powers in this regard.

(ii) The Reserve Bank does not obtain through periodic reporting or on-site examination, the names and holdings of all significant shareholders or those that exert a controlling influence, including the identities of beneficial owners of shares being held by nominees. However details of ‘substantial interest’ of promoters, the chairman, managing directors and CEO are part of the Certificate of Registration application form which is obtained by the Reserve Bank.

The Panel recommends that the Reserve Bank should explore the option of obtaining information on names and holdings of significant shareholders of NBFCs who exert a controlling influence, periodically through off-site returns.

8.3.4 Transfer of Significant Ownership

The existing guidelines do not define ‘significant ownership’ or ‘controlling interest’ for NBFCs. A definition of ‘substantial interest’ has, however, been given in the prudential guidelines.

The Panel recommends that the Reserve Bank should explore the possibility of defining ‘significant ownership’ or ‘controlling interest’. Further, it recommends that it should issue necessary guidelines to NBFCs advising them to intimate the Reserve Bank of any change in significant ownership.

8.3.5 Major Acquisitions

Investments by NBFCs are governed by the Prudential Norms Directions, 2007. However, the Reserve Bank has no power to review major acquisitions by an NBFC against any prescribed criteria. Establishment of cross-border operations and corporate affiliations or structures which could expose the NBFC to undue risks or hinder effective supervision is also not reviewed.

The Panel feels that given NBFCs’ developmental role in promoting new companies in the form of subsidiaries/ associates, they should not be constrained by any specific mandated criteria regarding acquisition. But, the Reserve Bank could consider obtaining information relating to cross-border operations and corporate affiliations as part of the off-site surveillance.

8.3.6 Reporting of Material Concentration to the Board

Though, the Reserve Bank has defined ‘group of connected counterparties’ and set prudent limits on large exposures to a single counterparty or a group of connected counterparties, it has not issued any instructions to NBFCs as regards review and reporting of material concentration to the Board.

The Panel feels that there is a need to issue guidelines for establishing thresholds depending on their respective scales of operation, and reporting exposures above the threshold to the board. This aspect can also be verified by the Reserve Bank during the on-site inspection of NBFCs.

8.3.7 Exposure to Related Parties

The Reserve Bank has not issued any guidelines regarding related party exposures.

The Panel feels that the requirement of issuance of guidelines on arms-length relationships and stipulations on mitigating risks arising out of related party exposure be examined, keeping in view the developmental and supporting role played by NBFCs in the promotion of green field projects, which they often do through subsidiaries and associates.

8.3.8 Market Risk and Liquidity Risk

The Reserve Bank has not issued any instructions to NBFCs to put in place policies and processes that accurately identify, measure, monitor and control market risks. The Reserve Bank has issued ALM guidelines which are applicable to NBFCs-D with deposits over Rs.20 crore or to NBFCs with an asset size of Rs 100 crore and above irrespective of whether they are accepting / holding deposits.

The Panel feels that NBFCs provide financial services similar to those of banks and, as such, compete with them. The non-deposit taking NBFCs’ investment portfolio comprises a significant portion of their balance sheets. Also, their off-balance sheet exposures are susceptible to market risk. Therefore, the Panel recommends that the Reserve Bank consider the feasibility of implementing guidelines on market risk on the lines of commercial banks to deposit-taking NBFCs (with deposits above Rs.20 crore) and NBFCs-ND-SI.

The Panel recommends a phased and calibrated implementation of capital charges for market risk in respect of these entities.However, it recommends that NBFCs not having any outstanding borrowing by way of public deposits or any other form of borrowing including preference shares could be considered for exemption from these guidelines. The Panel also feels that prudential norms for NBFCs particularly relating to ALM and liquidity risk management need to be strengthened in a non-disruptive manner.

8.3.9 Operational Risk

The Reserve Bank has not issued any guidelines to NBFCs to have in place risk management policies and processes to identify, assess, monitor and control / mitigate operational risk.

The Panel observes that capital adequacy requirements for NBFCs capture only credit risk. However, the capital adequacy requirements for NBFCs are higher than those for banks. The Panel feels that there is no need for issuing any guidelines on capital charges for operational risk for the present to NBFCs. However, guidelines on the management of operational risk without stipulating specific charges can be issued for NBFCs.

8.3.10 Balance of skills between front and back-office

The Reserve Bank does not determine whether there is an appropriate balance in the skills and resources of the back office and control functions relative to the front office/ business origination of NBFCs.

The Panel recommends that the Reserve Bank needs to look into the same during the on-site inspection of NBFCs-D. Specific provisions in the NBFC inspection manual required to be made in this regard. For NBFCs-ND-SI, this could be done during on-site scrutiny.

8.3.11 Abuse of Financial Services

(i) While granting permission for setting up a liaison office in India by a foreign NBFC, their operation from a tax haven country is accorded due cognizance.

The Panel recommends that the Reserve Bank should have in place formal due diligence policies and formal processes regarding such activities. Suitable guidelines should be issued in this regard.

(ii) There is no procedure for confirmation by the Reserve Bank of money-laundering prevention, identification and reporting of potential abuse.

The Panel recommends that there can be confirmation that NBFCs have sufficient controls and systems in place for preventing, identifying and reporting potential abuses of financial services including money-laundering through on-site inspection.

(iii) The Reserve Bank has issued detailed guidelines on Know-Your-Customer (KYC) to NBFCs. However, there are no laws in place which give protection to NBFC staff who report suspicious activity in good faith, either internally or directly to the relevant authority.

The Panel recommends that appropriate guidelines be issued along the lines introduced for private sector banks and foreign banks (Introduction of ‘Protected Disclosures Scheme for Private Sector and Foreign Banks’).

8.3.12 Notification to Regulator of Substantive Changes

The main instrument of supervision of NBFCs is the periodic on-site inspection that is supplemented by off-site monitoring and surveillance. However, there is no requirement to notify the Reserve Bank of any substantive changes in their activities, structure and overall condition or as soon as they become aware of any material adverse developments.

The Panel recommends that the Reserve Bank should issue requisite guidelines in this regard.

8.3.13 Appointment of Auditors

The Reserve Bank has no power to recommend, reject and rescind the appointment of auditors.

The Panel recommends issuance of appropriate guidelines to empower the Reserve Bank regarding the appointment, rejection and rescinding the appointment of external auditors. This may be done in consultation with ICAI.

8.3.14 Increased Disclosures

Disclosures made by NBFCs at present include both qualitative and quantitative information on financial performance, financial position, risk management strategies and practices, risk exposures, transactions with related parties, accounting policies and basic business, management and governance. The Reserve Bank could consider increased disclosures in case of NBFCs in respect of ownership structure, significant holdings and nature and types of activities and products.

Secction 9

Housing Finance Companies

9.1 Legal Arrangement and Organisational set-up for Regulation and Supervision

Housing finance has grown rapidly in the last two decades. Apart from housing finance companies (HFCs), the credit boom witnessed in the housing sector has also been fuelled by commercial banks and co-operative banks. Along with commercial and co-operative banks, housing finance companies (HFCs) remain a significant contributor to the housing growth in the country. The buoyant state of housing finance in India is evident from the fact that investment in housing as a proportion of GDP increased from 3.4 per cent in 2001 to 7.64 per cent in 2006. Further, the total disbursement of housing financé by HFCs and scheduled commercial banks increased from Rs.76,400 crore during 2004-05 to Rs.86,000 crore during 2005-06. Scheduled commercial banks were by far the most dominant, accounting for more than 65 per cent of total disbursement. Though, HFCs share in disbursement was lower at 34 per cent, the outstanding loan amount of housing loans was significant at Rs.89,400 crore at the end of March 2007. HFCs had public deposits to the tune of Rs.12,900 crore and borrowings of Rs.1,01,100 crore (of which borrowings from banks stood at Rs.48,800 crore) as on March 31, 2007 thereby establishing a systemic linkage. The largest HFC is also a financial conglomerate which has made a foray in several sectors including banking.

HFCs are regulated and supervised by the National Housing Bank (NHB) as per the provisions of the NHB Act, 1987 and Housing Finance Companies (NHB) Directions, 2001. They are also governed by the Companies Act, 1956, which falls within the jurisdiction of the Ministry of Corporate Affairs. Though the Core Principles for Effective Banking Supervision are not applicable to housing finance companies, the Panel feels the assessment of the regulation and supervision of HFCs based on the Core Principles would, nevertheless, be useful for the following reasons:

(i) The potential of overheating of the housing sector and the regulatory and supervisory mechanism in place to address consequent risks needs to be assessed.

(ii) Given the systemic linkages, HFCs are potential conduits for spreading systemic risk.

(iii) NHB has introduced risk-based capital requirements for HFCs which are similar to the Basel-stipulated norms.

(iv) As in the cases of NBFCs, there is scope for regulatory arbitrage between HFCs and banks, e.g., HFCs do not have to provide for standard assets in their housing loan portfolio while there are stipulated provisioning norms for banks in this regard.

(v) The assessment would throw up developmental issues, which, if implemented could strengthen the regulation and supervision of HFCs.

There were 43 HFCs registered with NHB as on January 25, 2008. Of these, the 12 large ones account for more than 90 per cent of the asset base. Others are insignificant in size and undertake only rudimentary operations.

9.2 Summary Assessment of Housing Finance Companies

The summary assessment of adherence to Basel Core Principles (BCPs) in respect of regulation and supervision of Housing Finance Companies (HFC) under the broad categories are given below. The detailed principle-wise assessment of Basel Core Principles for HFCs is furnished in Appendix 9.

9.2.1 Objectives, Autonomy and Resources (Principle 1)

All sub-components of the principle except for the one on independence, accountability and transparency, are fully compliant. NHB, which regulates and supervises HFCs, has clear responsibilities and objectives and possesses transparent processes, sound governance, and adequate resources.

There is no requirement for the public disclosure of the reasons for the removal of the head of NHB. Though Section 7 of the NHB Act provides for terms of appointment of the chairman of NHB it states that the Central Government can, in consultation with the Reserve Bank, remove the chairman after giving him a reasonable opportunity of showing cause against the proposed removal.

There is a suitable legal framework in place which include provisions relating to the licensing of HFCs, setting prudential rules and their ongoing supervision, empowering of supervisors to address compliance with laws to ensure the safety and soundness of HFCs, to have access to HFCs’ boards, management, etc., and to take action against HFCs indulging in unsound practices. Legal protection for supervisors is available under Section 46 of the NHB Act.

The NHB has arrangements in place for sharing of information with domestic regulators. There are no formal or informal arrangements in place for co-operation and information-sharing with foreign financial sector supervisors of HFCs and their companies which could be of material interest to the home or host supervisor.

9.2.2 Licensing Criteria (Principles 2 to 5)

The principle relating to licensing criteria is largely compliant. But, there remain significant gaps in respect of full compliance of permissible activities, major acquisitions and transfer of significant ownership.

The definition of an HFC is not specific and clear. The permissible activities of HFCs are not clearly defined by supervisor, or in laws or regulations. Section 29A(4)(g) of the NHB Act empowers the licensing authority (NHB) to set criteria for licensing HFCs. It also has the power to reject an application if the criteria are not fulfilled or if the information provided is inadequate. NHB carries out fit and proper test for promoters and senior management, but an examination of the record of criminal activities is not part of the exercise. NHB does not obtain a no-objection certificate from the home supervisor before issuing a licence to foreign HFCs intending to establish a branch or subsidiary in India.

The regulation does not define ‘significant ownership’ and ‘controlling interest’. NHB has no power to reject any proposal for a change in significant ownership if they do not meet criteria comparable to those used for approving new HFCs. NHB may, however, cancel a Certificate of Registration granted to an HFC if it is satisfied, inter alia, that the general character of the management or the proposed management of the housing finance institution shall be prejudicial to public interest or the interest of its depositors. NHB has no power to take appropriate action to modify, reverse or otherwise address a change of control of an HFC that has taken place without necessary notification or its approval. No specific instructions have been issued as regards major acquisitions or investments by an HFC which requires prior approval of the NHB.

9.2.3 Prudential Requirements and Risk Management (Principles 6 to 18)

HFCs are not required to implement Basel I guidelines. But NHB has stipulated a risk-based capital adequacy norm. Though the minimum capital requirement is related to credit risk, it is higher than the 9 per cent stipulated for banks. Of the 13 principles relating to prudential requirements and risk management, two relating to capital adequacy and problem assets are compliant; three relating to credit risk, large exposures and abuse of financial services are largely compliant; four relating to risk management, exposure to related parties, liquidity risk and internal control are materially non-compliant and four relating to market risk, country risk, operational risk and interest rate risk in banking book are non-compliant.

NHB has issued guidelines on capital adequacy which include both on and off-balance sheet items which are uniformly applicable to all the players in the housing finance sector. There is no blanket requirement for HFCs to have in place comprehensive risk management policies and processes to identify, evaluate, monitor and control or mitigate material risks,

As per the present regulatory framework, credit risk is generally being addressed to a significant extent. HFCs have a credit risk management process that takes into account the risk profile of the HFC with prudent policies and processes to identify, measure, monitor and control credit risk. NHB satisfies itself that HFCs establish and adhere to adequate policies and processes to manage problem assets and evaluates the adequacy of provisions and reserves.

NHB has powers under Section 30A of the NHB Act to require an HFC to increase its levels of provisions and reserves and/or its overall financial strength if it deems the level of problem assets to be a concern. NHB has to be satisfied that HFCs have policies and processes that enable the management to identify and manage concentrations within the portfolio, and it has set prudential limits to restrict HFCs’ exposures to single counterparties or groups of connected parties. The large exposure limits are thereby defined.

NHB has not issued any directions and also does not monitor aggregate exposures to related parties at present. It does not determine whether the senior management and Board members of HFCs have an understanding of the nature and level of risk being undertaken by them and the relation of same to adequate capital levels. Consolidated regulation is not in practice at present.

As per current practice, liquidity risk and interest rate risk are reported as a part of ALM returns. However, these ALM guidelines are applicable to only the larger HFCs. The capital charge for operational risk and market risk are yet to be considered as part of the required risk management structure for HFCs. No guidelines have been issued covering country or transfer risk.

NHB determines whether HFCs have in place internal controls which include the responsibilities of Boards and/or senior management and deal with organisational structure, accounting policies and processes, checks and balances, and safeguarding assets and investments. However, a detailed and rigorous assessment is not done. NHB has no power to bring about changes in the composition of boards and senior management to address prudential concerns.

As regards the abuse of financial services, NHB determines whether HFCs have adequate policies and processes in place, including strict KYC rules that promote high ethical and professional standards in HFCs and prevent them from being used for criminal activities. Though the Prevention of Money Laundering (PML) Act designates the Financial Intelligence Unit (FIU) as the appropriate authority for reporting such activities, HFCs are not required to report these to the supervisor. NHB does not determine whether adequate screening policies and processes are there when hiring staff. No whistle-blower policy is in place.

9.2.4 Methods of Ongoing Supervision (Principles 19 to 21)

The supervisory framework for HFCs is largely in place. All the three principles relating to methods of ongoing supervision viz., supervisory approach, supervisory techniques and supervisor y reporting are largely compliant.

As regards the supervisory approach, NHB has an adequate information system which facilitates the processing, monitoring and analysis of prudential information. But there is no formal mechanism in place for HFCs to notify the NHB informally of any substantive changes in their activities, structure and overall condition, or as soon as they become aware of any material adverse developments. A breach of legal or prudential requirements is required to be reported under the off-site monitoring mechanism by HFCs as also by the statutory auditors of HFCs in terms of the Housing Finance Companies (NHB) Directions, 2001.

The supervisory techniques comprise on-site inspection and off-site surveillance. NHB evaluates the work of HFCs’ internal audit functions, and determines whether, and to what extent, it may rely on the internal auditors’ work to identify areas of potential risk. But there is no structured mechanism in place. NHB is not legally empowered to obtain information from related non-financial companies.

9.2.5 Accounting and Disclosure (Principle 22)

The aforesaid principle is largely compliant. As regards accounting and disclosure, NHB ensures that each HFC maintains adequate records drawn up in accordance with accounting policies and practices that are widely acceptable internationally, and publishes on a regular basis information that fairly reflects its financial condition and profitability. Disclosures on risk management strategies and practices and risk exposures are not made in the balance sheets of HFCs.

9.2.6 Corrective and Remedial Powers

(Principle 23) The aforesaid principle is largely compliant. NHB has at its disposal a range of adequate supervisory tools to bring about timely corrective actions which include the ability (where appropriate) to revoke a licence or recommend its revocation. NHB participates in deciding when and how to effect the orderly resolution of a problem HFC situation. But there is no structured mechanism in place.

9.2.7 Consolidated Supervision and Cross-Border Banking (Principles 24 to 25)

Both principles are non-compliant. Consolidated supervision is not done as adequate powers are not there. No arrangement exists with foreign supervisory authorities to exchange information.

9.3 Recommendations

The Panel finds that the HFC sector is less closely regulated and supervised than banks.