1 A PROJECT REPORT ON IMPACT OF BASEL & OTHER INDIAN COMMITTEES RECOMMENDATIONS ON INDIAN BANKING SYSTEM In partial fulfillment of the Dissertation In Semester - IV of the Master of Business Administration Prepared by: Aayush Kumar Registration No: 13010121218 Under the Guidance of Prof. Shivaprasad.G Bangalore
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IMPACT OF BASEL & OTHER INDIAN COMMITTEES RECOMMENDATIONS ON INDIAN BANKING SYSTEM
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1
A PROJECT REPORT ON
IMPACT OF BASEL & OTHER INDIAN COMMITTEES
RECOMMENDATIONS ON INDIAN BANKING SYSTEM
In partial fulfillment of the Dissertation
In Semester - IV of the Master of Business Administration
Prepared by:
Aayush Kumar
Registration No: 13010121218
Under the Guidance of
Prof. Shivaprasad.G
Bangalore
2
Master of Business Administration
Declaration
This is to declare that the report entitled “IMPACT OF BASEL & OTHER INDIAN
COMMITTEES RECOMMENDATIONS ON INDIAN BANKING SYSTEM” is prepared
for the partial fulfillment of the Dissertation course in Semester IV of the Master
of Business Administration by me under the guidance of Prof. Shivaprasad.G.
I confirm that this dissertation truly represents my work. This work is not a
replication of work done previously by any other person. I also confirm that the
contents of the report and the views contained therein have been discussed and
deliberated with the Faculty Guide.
Signature of the Student :
Name of the Student : AAYUSH KUMAR
Registration No : 13010121218
3
Master of Business Administration
Certificate
This is to certify that Mr. Aayush Kumar Regn. No. 13010121218 has completed
the dissertation titled IMPACT OF BASEL & OTHER INDIAN COMMITTEES
RECOMMENDATIONS ON INDIAN BANKING SYSTEM under my guidance for the
partial fulfillment of the Dissertation course in Semester IV of the Master of
Business Administration
Signature of Faculty Guide:
Name of the Faculty Guide: Prof. SHIVAPRASAD. G
4
CONTENTS
Chapter Page no.
Abstract
List of Tables
List of Charts
1. INTRODUCTION………………………………………………8-28
1.1 Statement of BASEL Norms
1.2 Introduction of Narasimham Committee
1.3 Introduction of Raghuram Rajan Committee
1.4 Introduction of Indian Banking System
2. RESEARCH METHODOLOGY……………………………...29-33
2.1 Need of the Study
2.2 Research Design and Survey Design
2.3 Data Analysis
2.4 Research Methodology
2.5 Research Design
2.6 Project Objectives
2.7 Expected Outcomes
3. DATA ANALYSIS……………………………………………...34-71
3.1 BASEL III
5
3.2 Impact of BASEL III on Loan Spreads
3.3 Impact of BASEL III on Bank Capital
3.4 Narasimham Committee Recommendations and Action
3.5 Raghuram Rajan Committee Report Analysis
4. CONCLUSION & FINDINGS………………………………...72-84
4.1 BASEL III
4.2 Narasimham Committee
4.3 Raghuram Rajan Committee
5. REFERENCES…………………………………………………85-86
6
LIST OF CHARTS/DIAGRAMS
SR NO PARTICULARS PG NO
1 Structure of Indian Banking 22
2 Core Banking Sector Indicators in India 24
3 Interest Rates in India 25
4 Capital to Risk Weighted Assets Ratio-Bank GroupWise 25
5 CRAR Levels of Indian Banking 35
6 CRAR Levels of Indian Banking 41
LIST OF TABLES
SR NO PARTICULARS PG NO
1 Comparison of Capital Requirement Standards 34
2 Deductions from Capital BASEL III guidelines Vs. Existing RBI
Norms
34-35
3 Sample Distribution by Category of Scheduled Commercial Banks
in India
38-39
4 Stylized Balance sheet and Income Statement of Scheduled
Commercial Banks
39
5 Levels of Capital Adequacy Ratios of Banks in selected Economies 40
6 Comparison of Capital Requirement Standards 41-42
7 Deductions from Capital BASEL III guidelines Vs. Existing RBI
Norms
42-43
8 Impact of Key Factors of Capital Standards on Equity 43-44
9 Possible Impact of Capital Standards on Indian Banks 44
10 BASEL III compliance – Required Minimum Capital 45
11 Comparison of Results for Estimations of Bank Loan Spread for
SCBs
71-72
12 Comparison of Results for Estimations of Bank Loan Spread for
SCBs
72
13 Increase in Bank Lending Spreads for a One Percentage Point
Increase in Bank Capital
72
14 Summary of Findings of Different Studies on Capital Requirement
of Indian Banks
73
15 Cost Benefit Analysis of BASEL III for Indian Banking 74
7
ABSTRACT
The impacts of the global financial crisis coupled with domestic policy paralysis have dented
India’s growth prospects much more than what had been predicted. The implementation of
Basel III norms would considerably enhance the regulatory capital requirement of Indian
banks apart from subjecting them to rigorous regulatory monitoring. Undoubtedly, the
increased capital requirements would result in the increase in the cost to banks as well as to
borrowers. Given this context, this research project has adequately assessed the impact of the
new capital requirements introduced under the Basel III framework on bank lending rates
and loan growth and also estimated the extent of higher capital requirements for the Indian
banks.
This study has been successful in broadening and deepening the understanding of the
potential impact of Basel III framework along with other committee’s recommendations by
estimating the qualitative as well as quantitative impact of Basel III. This study observes that
new capital requirements under Basel III would have positive impact for Indian banks as they
raise the minimum core capital, introduce counter-cyclical measures, and enhance banks’
ability to conserve core capital in the event of stress through a conservation capital buffer. The
liquidity standard requirements would benefit the banks in managing the pressures on
liquidity in a stress scenario more effectively.
The study has estimated that the impact of Basel III on bank loan spreads would be 31 basis
points increase for every 1-percentage point increase in capital ratio and would go up to an
extent of 100 basis points for 6-percentage point increase in the capital ratio assuming that the
Risk weighted assets are unchanged. However, assuming the risk weighted assets to decline by
20 percent; the study finds that there would be 22 basis points increase for every 1-percentage
point increase in capital ratio and would go up to an extent of 68 basis points for 6-percentage
point increase in the capital ratio.
Estimating the additional capital requirements of Indian banks in the wake of Basel III
regime, this study estimates that with an assumed growth of RWAs at 10%, Indian banks
would require additional minimum tier-1 capital of INR 251106.57 Crores, and with RWAs
growth at 12% and 15%, the requirement is estimated to be respectively in the order of INR
336390.41 Crores and INR 474168.60 Crores.
It was one of the objectives of this study to make a cost-benefit analysis of the implementation
of Basel III in the Indian context. Accordingly, it is estimated that while the requirement of
additional minimum tier-1 capital would be INR 2,51,106 crores with RWAs assumed at 10%,
the probable prevention of loss-in-output due to a crisis (at a very conservative estimation)
would be in the range of INR 16,01,971 crores.
8
CHAPTER 1
INTRODUCTION
9
1.1 INTRODUCTION OF BASEL NORMS:
The Basel Banking Accords are norms issued by the Basel Committee on Banking Supervision
(BCBS), formed under the auspices of the Bank of International Settlements (BIS), located in
Basel, Switzerland. The committee formulates guidelines and makes recommendations on best
practices in the banking industry. The Basel Accords, which govern capital adequacy norms of
the banking sector, aim to ensure financial stability and thereby increase risk absorbing
capability of the banks.
The first set of Basel Accords, known as Basel I, was issued in 1988, with primary focus on
credit risk. It laid the foundation of risk weighting of assets and set objective targets of capital to
be maintained. Basel II was issued in 2004 with the objective of being more comprehensive. It
aimed at increasing capital adequacy by imposing a buffer for a larger spectrum of risk. As time
has gone by, we have witnessed the Basel norms failing to restrict two major crisis during its
tenure, the South Asian Crisis in 1998 and Sub-prime Mortgage Crisis in 2007, which raises
questions about its effectiveness. As the banking world prepares to comply with Basel III, the
effectiveness of the Basel accord has come under the radar.
The Committee seeks to achieve its aims by setting minimum supervisory standards; by
improving the effectiveness of techniques for supervising international banking business; and by
exchanging information on national supervisory arrangements. And, to engage with the
challenges presented by diversified financial conglomerates, the Committee also works with
other standard-setting bodies, including those of the securities and insurance industries.
The Committee's decisions have no legal force. Rather, the Committee formulates supervisory
standards and guidelines and recommends statements of best practice in the expectation that
individual national authorities will implement them. In this way, the Committee encourages
convergence towards common standards and monitors their implementation, but without
attempting detailed harmonization of member countries' supervisory approaches.
At the outset, one important aim of the Committee's work was to close gaps in international
supervisory coverage so that (i) no foreign banking establishment would escape supervision; and
(ii) that supervision would be adequate and consistent across member jurisdictions. A first step in
this direction was the paper issued in 1975 that came to be known as the "Concordat", which set
out principles by which supervisory responsibility should be shared for banks' foreign branches,
subsidiaries and joint ventures between host and parent (or home) supervisory authorities. In
May 1983, the Concordat was revised and re-issued as Principles for the supervision of banks'
foreign establishments .
In October 1996, the Committee released a report on The supervision of cross-border banking,
drawn up by a joint working group that included supervisors from non-G10 jurisdictions and
offshore centres. The document presented proposals for overcoming the impediments to effective
consolidated supervision of the cross-border operations of international banks. Subsequently
endorsed by supervisors from 140 countries, the report helped to forge relationships between
measurement, reporting framework and prudential limits.
In terms of managing the leverage by banks, RBI has been keeping a watch through the
prudential focus on credit-deposit ratio (CD ratio or CDR) and SLR. Moreover, a prudent focus
on CDR encourages the banks to raise deposits for funding credit flow thus minimizing the use
of purchased funds. Further, as the requirement for SLR is to hold unencumbered securities,
banks cannot leverage the minimum SLR portfolio to take on more assets. Accordingly, the
focus on credit deposit ratio and the SLR prescription have both served to limit the degree of
leverage in the Indian banking system.
Securitization of assets by Indian banks has been regulated by RBI under its guidelines issued in
February 2006. Accordingly, the banks (originators) are prohibited from booking profits upfront
at the time of securitization and also the release of credit enhancement during the life of the
credit-enhanced transaction is disallowed. In view of the same, banks were not having any
incentives to resort to unbridled securitization as observed in “originate-to-distribute57” and
“acquire and arbitrage”58 models of securitization as found in many other countries.
In order to contain the short-term liquidity crisis, RBI recognized the possible impact of
excessive inter- connectedness within the banking system, and has stipulated a restriction on
inter-bank liabilities (IBL) to twice the bank’s net worth. In addition, a higher limit up to 3 times
the net worth is allowed only for those banks whose CAR is at least 25% more than the
minimum of 9%. With a view to recognize the impact that restructuring of credit and slower
growth of credit could have on the credit quality of the banks and also considering the necessity
28
to build up provisions when the bank’s earnings are good, RBI has, in December 2009 advised
the banks to maintain a provision coverage ratio of not below 70% by September 2010.
29
CHAPTER 2
RESEARCH
METHODOLOGY
30
2.1 NEED OF THE STUDY:
The topic undertaken for the dissertation is “Impact of BASEL and Other Indian Committees
Recommendation on Indian Banking System”. The purpose behind opting this topic is immense
potential of the Indian banking sector. Half of the population still lives in the villages, which
needs to be included in the financial system for the inclusive growth of the economy and reduce
the NPAs.
In order to improve the banking sector, various committees have been formed such as
Narasimham committee, Raghuram Rajan committee etc for Indian banks. Similarly BASEL
committee had been formed in order to improve the banking sector worldwide by G10 countries.
As it is the era of globalization and liberalization, most of the economies have been linked with
each other. Anything happened in one country has cascading effect on the other countries’
economy. The effect was recently observed in the 2008 market crash and defaulting of various
European countries on their debt obligation (PIGS countries). Any crash or boom has one thing
in common and that plays a key role in order to make it happen. It is the money flow mechanism
of the countries’ banking sector liquidity. A fragile banking industry could not sustain the growth
of the economy for a longer period of time. This can be clearly proved by 2008 crisis, which
leads to the fall of many banking giants which were too large to fall.
2.2 RESEARCH DESIGN AND SURVEY DESIGN:
Research approach would be based on the quantitative & qualitative section. Here, the data and
information gathered would be in moreover in the form of text, comments or numeric value. We
have to screen all the collected data and information and scratch out the required information out
of that. Here, we have to rely on the information, comments or data released/provided by the
designated authorities related to the RBI. The data would be gathered and distributed in form of
text and numeric only and put at the required stages.
Accordingly considered research approaches is essential, as it permits researcher to draw more
conversant information about the selected research design; this information afterward permits the
researcher to acclimatize the research design and furnish for limitations (Easterby- Smith et al
2002) cited by Saunders (2007).
2.3 DATA ANALYSIS:
The Data would be analyzed from the texts, numeric information provided by the experts and
samples. This information would be segregated as per the requirement and the concrete
information will be distributed according to the required heads.
(A) Secondary Data – The data would be collected from the earlier Journals, and data
collected from the designated authorities
The data would be moreover in the form of numeric value of text information, so that has to be
converted into presentable or graphical form as per the requirement of the project.
31
2.4 RESEARCH METHODOLOGY:
(A) Historical research
It creates explanations & sometimes attempted explanations, of conditions, situations and events
that have occurred in near past. For Example, Any research that documents the evolution of
teacher training program since the turn of century, with the focus of defining the historical
origins of the content and processes of current programs (Postlethwaite, 2005)
Here, in this study, this methodology may solve the problem because, the study on Impact of
BASEL and other Indian Committees Recommendations on Indian Banking System.
(B) Descriptive research
It provides information about conditions, situations and events that occur in the current. For
example, a survey of the physical conditions of school building in order to establish a descriptive
profile of the facilities that exist in a typical school. (Postlethwaite, 2005)
This is a very elaborative and correct kind of research method, where we not only rely on the
past trends and studies but also can observe the current studies and current concepts. The study
on study on Impact of BASEL and other Indian Committees Recommendations on Indian
Banking System
(C) Correlation research
It involves the search for relationship between variables through the use of various measures of
statistical association. For example, an investigation of the relationship between teachers’
satisfaction with their job and various factors describing the provision and quality of teacher
housing, salaries, leave entitlements, and the availability of class room supplies. (Postlethwaite,
2005)
Correlation research method makes relationship between two variables. And our study does not
satisfy this methodology because we are studying on only study on Impact of BASEL and other
Indian Committees Recommendations on Indian Banking System. The sector selected is only
RBI Guidelines, i.e., if there would be comparison between two industries then it could be used.
(D) Causal research
It aims to suggest casual linkages between variables by observing existing phenomena and then
searching back through available data in order to try to identify plausible casual relationships.
For example, a study of factors related to student ‘drop out’ from secondary school using data
obtained from school records over the past decade. (Postlethwaite, 2005)
Our study regarding “Impact of BASEL and other Indian Committees Recommendations on
Indian Banking System” does not satisfy this kind of research methodology because, this study is
completely depended on the factual data and theories, and casual method simply solves the
problems which have been already almost solved. It means, this method is suitable when you
already know the results but you simply need any fact to support that.
32
(E) Experimental research
It is used in settings where variables defining one or more “causes” can be manipulated in a
systematic fashion in order to discern “effects’ on other variables. For Example, an investigation
of the effectiveness of two new textbooks using random assignment of teachers and students of
three groups – two groups for each of the new textbooks, and one group as a ‘control’ group to
use the existing textbook. (Postlethwaite, 2005)
Experimental research methodology is suitable where we are completely studying any field or
study which is altogether virgin and has not been touched earlier. And the researcher has to make
various experiments to come out on one result. Here, we are studying a field where, we are
moreover relied on the persons and information which is already existed in this field.
(F) Case study research
It generally refers to two distinct research approaches. The first consist of and in depth of a
particular student, classroom or school with the aim of producing a nuanced description of
pervading cultural setting that affects education, and an account of the interactions that take
place between students and other relevant persons. For example, an in-depth exploration of the
patterns of friendship between students in a single class, the second approach to case study
research involves the application of quantitative research methods to non-probability samples-
which provide results that are not necessarily designed to generalizable to wider populations. For
example, a survey of the reading achievements of the students in one rural region of a particular
country (Postlethwaite, 2005)
Case study research more over focus on the past data and past information, where we study a
case, which is almost similar to our current problem or study so, as such we are not dealing with
such kind of study or case, we are collecting desecrated information from different places and
gathering at one common place to come out on one judgment.
(G) Ethnographic research
It usually consists of a description of events that occur within the life of a group – with particular
reference to the interaction of individuals in the context of socio cultural norms, rituals and
beliefs shared by the group. The researcher generally participates in some part of the normal life
of the group and uses what he or she learns from his participation to understand the interactions
between group members. For example, a detailed account of the daily tasks and interactions
encountered by a school principal using observations gathered by a researcher who is placed in
the position of “Principal’s Assistant’ in order to become fully involved in the daily life of the
school. (Postlethwaite, 2005)
This type of method suffices the kind the research which is not based on data and facts but on the
social and cultural behavior of the people, for example to understand the customers purchasing
behavior etc. So, our study does not suit this method.
(H) Research and development research
It differs from the above types of research in that, rather than bringing new information to light,
it focuses on the interaction between research and the production and evaluation of a new
product. This type of research can be ‘formative’. For example, an investigation of teachers’
33
reactions to the various drafts and redrafts of a new mathematics teaching kit, with the
information gathered at each stage being used to improve each stage of the drafting process.
Alternatively, it can be used summative. For example, a comparison of the mathematics
achievements of student exposed to anew mathematics teaching kit in comparison with students
exposed to the established mathematics curriculum. (Postlethwaite, 2005)
Well, this kind of method itself defines that it is not suitable for our study, which we are doing
on “Impact of BASEL and other Indian Committees Recommendations on Indian Banking
System”.
So, finally, from all the above mentioned research methodology, we reached on the point that,
the current study “Impact of BASEL and other Indian Committees Recommendations on Indian
Banking System” satisfy the Descriptive research method. Because, here we are suppose to deal
with the information and data which is based on the past facts and figures and at the same
moment current judgment and studies.
2.5 RESEARCH DESIGN:
Phase I- Exploratory work
Exploratory information has been collected from the interviews (mentioned in various journals)
of the various senior officials related BASEL & Other committee recommendations in RBI
Journals.
Phase II- Descriptive research
Descriptive study is done from the various journals, websites & from the books of the authors,
who have specifically written about the BASEL & Other committee's recommendations.
Research Type: Descriptive.
2.6 PROJECT OBJECTIVE:
Research on the recommendation of BASEL committees.
Research on the recommendation of Indian banking committees such as Narasimham
committee, Raghuram Rajan committee etc.
Before and after the implementation of these recommendation in the banking industry.
Analysis of the bank’s balance sheet for the improvements after the recommendation.
2.7 EXPECTED OUTCOME:
Better understanding of the banking industry regulation.
Banking structure in India.
Regulatory structure of the banks in Indian and global.
Impact of the committee’s recommendation on Indian banking sector.
Various risks faced by the banks.
Day to day capital requirements by the banks for their smooth operation
34
CHAPTER 3
DATA ANALYSIS
35
3.1 BASEL III:
Basel III guidelines attempt to enhance the ability of banks to withstand periods of economic and
financial stress by prescribing more stringent capital and liquidity requirements for them. The
new Basel III capital requirement would be a positive impact for banks as it raises the minimum
core capital stipulation, introduces counter-cyclical measures, and enhances banks’ ability to
conserve core capital in the event of stress through a conservation capital buffer. The prescribed
liquidity requirements, on the other hand, would bring in uniformity in the liquidity standards
followed by the banks globally. This liquidity standard requirement, would benefit the Indian
banks manage pressure on liquidity in a stress scenario more effectively. Although implementing
Basel III will only be an evolutionary step, the impact of Basel III on the banking sector cannot
be underestimated, as it will drive significant challenges that need to be understood and
addressed. Working out the most cost-effective model for implementation of Basel III will be a
critical issue for Indian banking.
Impact on Financial System - Basel III framework implementation would lead to reduced risk of
systemic banking crises as the enhanced capital and liquidity buffers together lead to better
management of probable risks emanating due to counterparty defaults and or liquidity stress
circumstances. Further, in view of the stricter norms on Inter-bank liability limits, there would be
reduction of the interdependence of the banks and thereby reduced interconnectivity among the
banks would save the banks from contagion risk during the times of crises.
Undoubtedly, Basel III implementation would strengthen the Indian banking sector’s ability to
absorb shocks arising from financial and economic stress, whatever the source be, and
consequently reduce the risk of spillovers from the financial sector to the real economy.
On Weaker Banks- Further, there would be a drastic impact on the weaker banks leading to their
crowding out. As is well established, as conditions deteriorate and the regulatory position gets
even more intensive, the weaker banks would definitely find it very challenging to raise the
required capital and funding. In turn, this would affect their business models apart from tilting
the banking businesses in favor of large financial institutions and thereby tilting the competition.
Increase Supervisory Vigil - Banking operations might experience a reduced pace as there
would be an increased supervisory vigil on the activities of the banks in terms of ensuring the
capital standards, liquidity ratios – LCR and NSFR and others.
Reorganization of Institutions - The increased focus of the regulatory authorities on the
organizational structure and capital structure ability of the financial firms (mainly banks) would
lead the banks to reorganize their legal identity by resorting to mergers & acquisitions and
disposals of portfolios, entities, or parts of entities wherever possible.
International Arbitrage - In case of inconsistent implementation of Basel III framework among
different countries would lead to international arbitrage thereby resulting in disruption of global
financial stability.
36
Capital standards for India - Indian banks need to look for quality capital and also have to
preserve the core capital as well as use it more efficiently in the backdrop of Basel III
implementation. Indian banks look comfortably placed; they will have to phase out those
instruments from their capital that are disallowed under Basel III.
Comparison of Capital Requirement Standards
Minimum Capital Ratios Basel
III of
BCBs
Basel III
of RBI
Existing
RBI
norms
PSBs
Current
Position
Private
Banks
Current
Position
Minimum Common Equity Tier 1
(CET1)
4.5% 5.5% 3.6% 7.3% 11.2%
Capital Conservation Buffer
(CCB)
2.5% 2.5% - - -
Minimum CET1 + CCB 7% 8% 3.5% 7.3% 11.2%
Minimum Tier 1 Capital 7% 7% 3.6% 7.3% 11.2%
Minimum Total Capital Including
Buffer
8% 9% 6% 8.1% 11.5%
Minimum Total Capital + CCB 10.5% 11.5% 9.0% 12.1% 15.9%
Additional Counter Cyclical
Buffer in the form of Common
Equity Capital
0-
2.5%
0-2.5% NA NA NA
Source: RBI Guidelines
Deductions from Capital – Basel III guidelines Vs. Existing RBI norms
Particulars BASEL III of RBI Existing RBI Norms Impact
Limit on deductions
Deductions would be
made if deductibles
exceed the 15% of
core capital at an
aggregate level, or
10% at the individual
item level.
All deductibles to be
deducted
Positive
Deductions from Tier
I or Tier II
All deductions from
core capital
50% of the deductions
from Tier I and
remaining 50% from
Tier II capital
(excepting DTAs and
intangibles where
100% deduction is
made from Tier I
capital
Negative
Treatment of
significant
Aggregated total
equity investment in
For investments upto:
(a) 30%:
Negative
37
investments in
common shares of
unconsolidated
financial
entities
entities where banks
own more than 10%
of shares • (a) Less
than 10% of banks’
common equity – 250
risk
weight (b) More than
10 % will
be deducted from
common
equity
125% risk weight or
risk weight as
warranted by external
rating
(b) 30-50%: 50%
deduction from Tier I
capital and 50% from
Tier II capital
Source: RBI Guidelines
Out of 10.50%, total equity, the capital (equity + reserves) requirement is hiked from the existing
2% to 7%. However, tier II capital that is hybrid capital (fund raising through mostly debt
instruments) dumped from 4% to 2%. Further, with the stipulation of “countercyclical buffer” of
up to 2.5%, the total CAR requirement would raise upto 13%.
Though Indian banks are undoubtedly well capitalized, and maintaining a higher equity capital
ratio than stipulated under Basel III guidelines, they are indeed required to strengthen their
common equity after the relevant deductions. Investor preference would require the banks to
ensure that all the banks would have to maintain an equity capital ratio of higher than 7% by
2013.
CRAR Levels of Indian Banking
Source: Developed by author based on data from RBI Publications
In view of the predicted favorable economic growth over the next three years, it would enable
the banks to shore up their capital bases through issuance of equity. However, a few of the below
38
average performing banks may be necessitated to raise additional equity capital to maintain the
required 7%.
3.2 IMPACT OF BASEL III ON LOAN SPREADS:
The purpose of this section is to map the capital and liquidity requirements as per Basel III to
bank lending spreads. This estimation supposes that the return on equity (ROE) and the cost of
debt are unaffected, with no change in other sources of income and on the same line of thought it
is further assumed that there is no reduction in operating expenses. Such a mapping endows
researchers with a useful instrument to analyze the impact of regulatory changes on the cost of
credit and the real economy. A raise in the interest rate charged on bank loans is believed to
reduce loan demand, all else equal, leading to a drop in investment and output.
This methodology has been employed in the BCBS’s assessment of the long-term economic
impact of the proposed regulatory changes on output (BCBS, 2010, King, 2010). Further, the
benefit of these estimates of changes in bank lending spreads could be found in the using them as
inputs into dynamic stochastic general equilibrium models that have been augmented to include a
micro-founded banking sector such as Goodfriend and McCallum (2007), or as a proxy for
increased financial frictions in macroeconomic models that lack a financial sector. Similar to the
studies by Repullo and Suarez (2004) and Ruthenberg and Landskroner (2008) for Basel II
framework, this mapping exercise attempts to illustrate the potential loan pricing implications for
the banks under the Basel III proposals.
A representative bank is designed to map the changes in the bank’s capital structure and to
understand how the composition of assets has an effect on the different components of net
income using the standard accounting relationships. Even though banks can adjust to the
regulatory reforms in several ways, this study supposes that they seek to pass on any additional
costs by raising the cost of loans to end-customers. It is believed that by computing the change in
net income and shareholder’s equity associated with the regulatory changes, we can compute the
increase in lending spreads required to achieve a given return on equity (ROE).
Of course, this approach is not without limitations. This approach does not formally model the
choices faced by the banks, nor does it offers estimates based on an optimization in a general
equilibrium setting. On other hand, as a substitute, it offers a starting point for understanding the
behavioral response of banks to a regulatory change in a most acceptable practical setting. It
enables and the researchers and the policy makers in determining the impact given a country’s
institutional setting, its banking sector and the elasticity of loan demand.
Though this approach can suggest the potential magnitude of the change in lending spreads,
deciding whether banks would be able to pass on these costs to borrowers is beyond the scope of
this study. Further, this approach focuses on the ‘steady state’ and does not consider the
transition period to the higher regulatory requirements. In the steady state, the supply of bank
credit is considered as exogenous and credit rationing is ignored. It is further implied that banks
price their loans to meet the marginal cost of loan production.
39
As this approach is understandably illustrative and general in nature and could be used to
estimate the impact on lending spreads from a change in bank’s capital structure, assets
composition, risk weighted assets and the corporate tax paid by these banks. Also, as this
approach does not rely much on the availability of very large datasets (which are obviously the
requirement in effective use of statistical methods); it is acceptable particularly for practitioners
for easy comprehension. Another advantage of this approach is that it explains how a given
change can alter the bank’s profitability and indicates to different possible behavioral responses
to the regulations including the unintended consequences. Further, this approach being a bottom-
up, micro-founded one, it offers a useful complement to top-down, structural models where the
modeling of the financial sector is necessarily parsimonious. Although this approach is founded
on several assumptions, all the assumptions are apparent, realistic, and simple and can be
modified to check the sensitivity of the results.
This approach focuses on only two elements of Basel III proposals viz., the first relating to
raising the minimum capital requirement and the second relating to enhanced liquidity
requirement. Firstly, though the previous Basel accords (Basel I and II) specified capital
adequacy rules for minimum capital adequacy ratios, however, they could not absorb the losses
during the recent crisis. In this backdrop, Basel III stipulates higher levels of tangible common
equity. In order to achieve this, banks need to increase their common equity with high- quality
capital. Although this can be achieved by deleveraging banks’ balance sheets by offloading
assets in the near term, but it does not change the fact that the relative share of common equity
and liabilities need to change.
Secondly, as per the Basel III framework, banks are required to meet two new liquidity standard
requirements viz., liquidity coverage ratio (LCR) and net stable funding ratio (NSFR). The LCR
is employed to identify the amount of unencumbered, high quality, liquid assets that can be made
use of to offset cash outflows. Basically, LCR aims to ensure that banks have adequate funding
liquidity to survive at least one month of a situation of stressed funding. As the related data
(requires details on a bank’s expected cash outflows over a one-month period) is not available
for researchers, it cannot be calibrated. The aim of NSFR is to address maturity mismatches
between assets and liabilities. NSFR establishes a minimum adequate amount of stable funding
based on the liquidity characteristics of a bank’s assets over a one-year horizon. This approach
estimates the cost to meet the NSFR. This approach mostly follows the footsteps of King (2010)
in estimating the impact of capital and liquidity requirements on the lending spreads.
This section of the study does not focus on measurement of credit risk, but on the relationships
between a bank’s capital structure, asset composition and their impact on bank’s profitability.
This greater level of detail is vital for understanding as to how the banks respond to the Basel III
regulatory reforms. Both theorists and researchers are quite concerned in understanding these
relationships, albeit they may be too complex to model parsimoniously. By offering greater
detail on the significance of different sources of capital, the present study also contributes to a
growing literature on bank capital structure choices and their impact on lending.
Elliott (2010) is one of the recent studies that has analyzed the loan pricing implications of the
proposed higher capital requirements under Basel III. By providing an accounting-based
analysis, Elliott (2010) has estimated how much the interest rate charged on loans would increase
if banks are required to hold more equity. However, in the stylized model of Elliot, banks hold
40
only loans funded by equity, deposits and wholesale funding and the interest rate on loan is
priced in order to meet a targeted ROE after covering for the cost of liabilities and other fixed
expenses (such as administrative costs and expected loan losses). Using the Federal Deposit
Insurance Corporation (FDIC) data for aggregate United States (US) banking system, Elliott has
calculated that if the ratio of common equity required for a given loan is raised by 2% with no
other changes, banks would need to raise lending spreads by 39 basis points (bps) to maintain the
target ROE of 15%. Further, if the ROE is allowed to fall to 14.5%, lending spread would have
raise only by 9 bps. Elliott summarizes that through a combination of actions the US banking
system would be able to adjust to higher capital requirements and ensure that they would not
have a strong effect on the pricing or availability of bank loans. The merit of the Elliott’s method
is in its simplicity as well as the intuition it provides on pricing of loans and the alternatives
available to banks to adjust to higher capital levels.
The approach of this section of the study is influenced largely by Elliott as well as King’s
approaches. By actual usage of the balance sheet data to compute the regulatory impact, it takes
into account the composition of the assets and liabilities as well the very important distinction
between the assets and risk weighted assets. Further, it models the cost meet the NSFR
unambiguously, elucidating the sensitivity of this computation to the inputs. This study makes an
attempt to compare two steady states, namely, one with and other one without the regulatory
requirements. Firstly, I consider the impact of higher capital requirements in isolation, and then
the cost to meet the NSFR is computed assuming the higher capital requirements have already
been met. Lastly, by considering the potential synergies between the two regulatory
enhancements, it models the capital and liquidity requirements together.
Lending Spreads - A more popular definition for the lending spread is that it is the difference
between the interest rate charged on loans and the rate paid on deposits (Repullo and Suarez,
2004). Goodfriend and McCallum (2007) determine the lending spread as the difference between
the uncollateralized lending rate and the interbank rate. Further, the rate charged by banks on
loans varies on several factors like; terms of the loan, the characteristics of the borrower, the
collateral provided and other costs associated with the loan.
Constructing a representative bank’s financial statements - Stylized balance sheet and income
statement data for scheduled commercial banks in India has been collected from Capitaline Plus
database, respective websites of the banks under study, RBI data- base, and Basel II Pillar III
disclosures of respective banks from their websites. The data employed for analysis is for the
period from 2002 to 2011 as the Capitaline Plus database provides complete datasets only for a
ten-year period IDBI Bank Ltd. in spite of its dual nature, it is also included amongst the public
sector banks. Public sector banks category also includes the State Bank of India and its associate
banks. Private sector banks also include the foreign banks operating in India. Scheduled
commercial banks (SCBs) include both the public and private sector banks.
41
Sample Distribution by Category of Scheduled Commercial Banks in India
Year Public Sector Banks Private Sector Banks SCBs
2002 30 87 117
2003 30 94 124
2004 30 93 123
2005 30 97 127
2006 30 88 118
2007 30 86 116
2008 30 83 113
2009 29 69 98
2010 29 87 116
2011 28 85 113
2014 27 68 95
Source: RBI Guidelines
The number of banks varies by year due to the merger, closure, or entry of a new foreign bank in
the year. Capitaline Plus database does not report RWAs directly in its datasets. Instead the
quantity of RWAs is collected from the more authenticate source; i.e. the Basel II Pillar III
disclosures of respective banks from their websites. Since the Capitaline Plus database presents
the data for category of banks, there was no problem of the outliers and the requirement of
winsorization of capital adequacy ratios to reduce the impact of outliers. Based on the data
described, a representative bank balance sheet and income statement is constructed for each
category of banks by taking the weighted average values for each component of the balance
sheet and the income statement for banks in each category of study. The weights are based on
total assets of the category of the banks.
Stylized Balance sheet and Income Statement of Scheduled Commercial Bank
BALANCE SHEET AVERAGE INCOME STATEMENT AVERAGE
Cash & Balances with RBI 5.59 Interest Income 6.21
Interbank Claims 4.09 Interest Expended 3.97
Investment & Securities 31.48 A. Net Interest Income 2.24
Loans & Advances 53.23 B. Other Income 1.28
Fixed Assets 0.99 C. Total Revenue (A+B) 3.52
Other Assets 4.63 D. Personnel Expenses 0.95
TOTAL ASSETS 100.00 E. Other Administrative Exp 1.37
Deposits by Customer (Retail 75.65 F. Operating Expenses (D+E) 2.32
42
& Corporate)
Interbank Funding Borrowings 9.16 G. Operating Profit (C-F) 1.20
Other Liabilities & Provisions 8.06 H. Tax Provisions 0.36
TOTAL LIABILITIES 92.88 I. Net Income (G-H) 0.84
Capital 1.05
Reserves Total 6.06
Equity Share Warrants 0.00
Equity Application Money 0.00 Return on Equity (ROE %) 0.15
Total Capital 7.12 Leverage Multiple 6.60
TOTAL LIAB & CAPITAL 100.00
Risk Weighted Asset / Total
Asset
65.77 Average Effective Tax Rate
(%)
33.00%
Source: RBI Guidelines
Loans & advances represent about more than half of the typical banks assets, followed by investments & securities (31.48%), cash and balances with RBI (5.59%), other assets (4.63%) and interbank claims (4.09%). These assets are funded mainly by deposits (75.65%), bank borrowings or interbank funding (9.6%). Shareholder’s equity is to the extent of 7.12%. RWAs constitute around 65.77% total assets on average. This ratio is significant when calculating the cost of meeting the higher capital requirement. Table-7.2.2 also shows the consolidated income statement for the representative bank. In terms of the composition of net income, net interest income is 2.24% with non-interest income also important at 1.28%. Total operating expenses constitute 2.32% of total assets. Personnel expenses represent around 41% of total operating expenses. Net income (or ROA) is 0.8%, implying that the average ROE is around 15%. The average historical corporate tax rate is accepted at 33%. 3.3 IMPACT OF BASEL III ON BANK CAPITAL:
Post crisis, on the global there have been sincere efforts towards improving the capital adequacy
of the banks. Capital adequacy levels across banks in most advanced economies were on a rise
between 2008 and 2010. For instance, by 2010, in the US, UK, Germany, and Japan, Capital to
Assets Ratio (CAR) was found to be above 15 per cent. The ratio showed a further increase for
US and German banks in the first quarter of 2011. However, among the major emerging
economies, the level of capital adequacy exhibited a moderate decline between 2009 and 2010,
with the exceptions of China, India, and Mexico. How- ever, Chinese banks experience a modest
decline in their capital positions by March 2011.
Levels of Capital Adequacy Ratios of Banks in Select Economies
Countries 2007 2008 2009 2010 2011 2014
Advanced Economies
France 10.2 10.5 12.4 12.3 …. 12.7
Germany 12.9 13.6 14.8 16.1 16.6 17.3
Greece 11.2 9.4 11.7 11.4 12.3 12.6
Italy 10.4 10.8 12.1 12.3 …. 12.7
Japan 12.3 12.4 15.8 16.7 …. ….
Portugal 10.4 9.4 10.5 10.2 10.5 10.7
Spain 11.4 11.3 12.2 11.8 …. 12.5
43
United Kingdom 12.6 12.9 14.8 15.9 …. 17.1
Unites States 12.8 12.8 14.3 15.3 15.5 ….
Emerging & Developing Economies
Brazil 18.7 18.2 18.9 17.6 18.2 …..
China 8.4 12 11.4 12.2 11.8 …
India 12.3 13 13.2 13.6 …. 14.1
Malaysia 14.4 15.5 18.2 17.5 16.4 16.2
Mexico 15.9 15.3 16.5 16.9 16.5 16.1
Russia 15.5 16.8 20.9 18.1 17.2 17.9 Source:Dr.Swamy“BaselIII:ImplicationonIndianBanking” & http://data.worldbank.org/indicator/FB.BNK.CAPA.ZS
Notwithstanding the progress in CAR, soundness of global banks remained a concern because of
a slow process of deleveraging and increasing levels of NPAs. There has been asymmetry in the
decline in banking sector leverage across countries after the crisis. The percentage of total capital
(and reserves) to total assets has been taken as an indicator of leverage in the banking system.
However, deleveraging has not gained any significant momentum in the banking systems of
other advanced European economies, viz., France, Germany, Portugal, Greece, and Spain,
treating 2008 as the reference point. Further, there was a general weakening of the asset quality
of top global banks. Further, according to RBI, financial soundness of the banking sector is a
sine qua non for the financial system’s stability in a bank-dominated country like India. In the
Indian context, the CAR, however, has weakened in 2010-11 over the previous year mostly due
to a decline in Tier II CAR ratio. Amongst the bank groups, foreign banks have registered the
highest CAR, followed by private sector banks and PSBs in 2010-11. Under Basel II also, the
CAR of SCBs remained well above the required minimum in 2010-11. This implies that, in the
short to medium term, SCBs are not constrained by capital in extending credit.
CRAR Levels of Indian Banking
Source: Dr. Swamy “Basel III: Implication on Indian Banking”
44
According to RBI (RBI 2011), Indian banks can comfortably cope with the proposed Basel III
framework, as they may not face huge difficulty in adjusting to the new capital rules in terms of
both quantum and quality. Quick estimates of RBI (based on the data furnished by banks in their
off-site returns) observe that the CAR of Indian banks under Basel III will be 11.7 per cent (as on
June 30, 2010) as compared with the required CAR under proposed Basel III at 10.5 per cent.
Capital Requirement Standards in Indian Context
Indian banks need to look for quality capital and also have to preserve the core capital as well as
use it more efficiently in the backdrop of Basel III implementation. Out of 10.50%, total equity,
the capital (equity + reserves) requirement has been hiked from the existing 2% to 7%. However,
Tier II capital that is hybrid capital (fund raising through mostly debt instruments) dumped from
4% to 2%. Further, with the stipulation of “counter-cyclical buffer” of up to 2.5%, the total CAR
requirement would raise upto 13%.
Comparison of Capital Requirement Standards
Minimum Capital Ratios Basel
III of
BCBs
Basel III
of RBI
Existing
RBI
norms
PSBs
Current
Position
Private
Banks
Current
Position
Minimum Common Equity Tier 1
(CET1)
4.5% 5.5% 3.6% 7.3% 11.2%
Capital Conservation Buffer
(CCB)
2.5% 2.5% - - -
Minimum CET1 + CCB 7% 8% 3.5% 7.3% 11.2%
Minimum Tier 1 Capital 7% 7% 3.6% 7.3% 11.2%
Minimum Total Capital Including
Buffer
8% 9% 6% 8.1% 11.5%
Minimum Total Capital + CCB 10.5% 11.5% 9.0% 12.1% 15.9%
Additional Counter Cyclical
Buffer in the form of Common
Equity Capital
0-
2.5%
0-2.5% NA NA NA
Source: Dr. Swamy “Basel III: Implication on Indian Banking”
Indian banks look comfortably placed. They will have to phase out those instruments from their
capital that are disallowed under Basel III.
Deductions from Capital – Basel III guidelines Vs. Existing RBI norms
Particulars BASEL III of RBI Existing RBI Norms Impact
Limit on deductions
Deductions would be
made if deductibles
exceed the 15% of
core capital at an
aggregate level, or
10% at the individual
item level.
All deductibles to be
deducted
Positive
45
Deductions from Tier
I or Tier II
All deductions from
core capital
50% of the deductions
from Tier I and
remaining 50% from
Tier II capital
(excepting DTAs and
intangibles where
100% deduction is
made from Tier I
capital
Negative
Treatment of
significant
investments in
common shares of
unconsolidated
financial
entities
Aggregated total
equity investment in
entities where banks
own more than 10%
of shares • (a) Less
than 10% of banks’
common equity – 250
risk
weight (b) More than
10 % will
be deducted from
common
equity
For investments upto:
(a) 30%:
125% risk weight or
risk weight as
warranted by external
rating
(b) 30-50%: 50%
deduction from Tier I
capital and 50% from
Tier II capital
Negative
Source: Dr. Swamy “Basel III: Implication on Indian Banking”
Dynamics of the Likely Impact on Bank Capital
The move to Basel III would enhance the need for capital based on the computation of risk-
weighted assets. In the current Indian banking context, risk- weighted assets are computed based
on standardized approaches. The shift from standardized approaches to risk-based approaches
would enable the Indian banks to rationalize the utilization of risk capital. Under credit risk,
transition from standardized approaches to foundation level internal-risk based approaches can
reduce the capital requirements considerably.
According to (BCBS, 2010), operational risk capital for non-AMA banks is higher than for AMA
banks, regard- less of the exposure indicator used for scaling. As such, under operation risk,
transition to advanced measurement approaches (AMA) is likely to increase the requirement of
market risk capital. Further, the introduction of incremental risk charge for credit risk in the
trading book and stressed VaR is expected to further increase risk-capital requirements.
Exposing the avail- able-for-sale (AFS) portfolio to market risk will further increase the
requirement for capital. Accordingly, transition towards advanced approaches to credit and
operational risk is expected to moderate capital requirements. However, there it is essential to
restructure market risk portfolios in line with the return on capital (RoC) deployed.
46
The new capital requirements as suggested under Basel III is a positive move for Indian banks as
it raises the core capital in the form of common equity, brings in the conservation and counter-
cyclical measures which in order to enable banks to conserve core capital in event of loss.
Though Indian banks are undoubtedly well capitalized, and maintaining a higher equity capital
ratio than stipulated under Basel III guidelines, they are indeed required to strengthen their
common equity after the relevant deductions. Investor preference would require the banks to
ensure that all the banks would have to maintain an equity capital ratio of higher than 7% by
2013.
Impact of Capital Standards
Basel III capital standards framework has indeed greatly revolutionized the capital structure of
banks putting onus on the banks to significantly raise their common equity, common equity,
additional Tier-I capital and Tier-II impact of the key factors of the Basel III regulations on
capital.
Impact of Key factors of capital standards on Equity tiers
Key Factors Impact on
Common
Equity
Capital
Impact on
Additional
Tier-I
Impact on
Additional
Tier-II
Increase in credit deployment Increase Increase Increase
Definition of common equity to exclude share
premium resulting from non-common equity
capital
Increase Decrease NA
Deductions made from common equity
instead of Tier 1 capital
Increase NA NA
Introduction of capital buffer Increase Increase Increase
Increase in capital requirements Increase Increase Increase
Transition to advanced approaches of credit
risk
Decrease Decrease Decrease
Transition to advanced approaches of
operation risk
Decrease Decrease Decrease
Transition to advanced measurement
approaches for measuring market risk
Increase --- ----
Source: Dr. Swamy “Basel III: Implication on Indian Banking”
Possible impact of capital standards on Indian banks
Key Recommendations of BASEL III Possible Impact
Increased quality of capital
May lead to capital raising by banks besides
retention of profits and resorting to reduced
Dividends
Increased quantity of capital
Banks will face additional capital requirement
and hence would raise common equity or
otherwise retain dividends
47
Reduced leverage ratio
This could lead to reduced lending apart from
banks be- coming very choosy in financing the
projects. Banks may reduce credit exposure
and potential credit losses through stricter
credit approval processes and, potentially
through lower limits, especially with regard to
bank exposures. Banks may focus on higher-
risk/higher return lending Pressure arises on
banks to sell low margin
assets
Source: Dr. Swamy “Basel III: Implication on Indian Banking”
BASEL III: Capital Projections for Indian Banks
In the wake of the new Basel III regime in the Indian context, it is attempted in this section of the
study to estimate the required additional minimum Tier-1 capital for the banks. This would
enable the banks to plan their capital raising activity in tune with regulatory requirements. This
exercise is carried out based on the data sourced from Capitaline plus database. As such, these
estimates at the best can be termed as approximations as these have data limitations with regard
to details required in the estimation process.
The methodology adopted includes the estimation process based on the reported Tier-1, Tier-2
capital, total capital and RWAs sourced from the Basel disclosures made by the banks in their
websites. The data for all the scheduled commercial banks has been collected accordingly and
grouped based on the bank groups namely; public sector banks and private banks. The important
assumption made in the estimation process is that RWAs of these banks grow by 10 percentage
points annually in Scenario-1 and 12% per annum in scenario-2 and 15% in Scenario-3. This
increase in RWAs is considered because of the reasoning that the banks grow their loan book
size approximately in the range of 20-25% and also considering the past trend of RWAs.
The estimates are presented in the tables here below. With an assumed growth of RWAs at 10%,
banks in India would require additional minimum tier-1 capital of INR 2,51,106.57 Crores. With
RWAs growth at 12% and 15%, the requirement would be in the order of INR 336390.41 crores
and INR 474168.60 crores respectively.
BASEL III Compliance – Required Minimum Capital
By Year PSBs Private Bank Total
Scenario – 1 with 10% growth in RWAs
2013 6173.54 0.00 6173.54
2014 16206.69 0.00 16206.69
2015 62103.88 2254.28 64358.16
2016 82070.48 5158.26 87228.74
2017 137120.89 13263.44 150384.33
2018 214104.12 37002.44 251106.57
Scenario – 2 with 12% growth in RWAs
48
2013 7188.12 0.00 7188.12
2014 30403.23 5.48 30408.72
2015 75469.86 4694.77 80164.63
2016 119891.65 10265.87 130157.51
2017 184195.79 30028.58 214224.37
2018 274793.18 61597.23 336390.41
Scenario – 3 with 15% growth in RWAs
2013 7049.99 0.00 7049.99
2014 110613.04 1099.52 111712.56
2015 117188.41 8601.80 125790.21
2016 170369.71 22517.34 192887.06
2017 256646.88 51563.57 308210.45
2018 378891.07 95277.53 474168.60 Source: Dr. Swamy “Basel III: Implication on Indian Banking”
A study by rating agency Fitch estimates the additional capital requirements at about INR 2.5
lakh crores to 2.75 lakh crores for Indian banks. Moody’s Indian subsidiary ICRA said banks in
the country would re- quire equity capital ranging from Rs 3.9 lakh crores to Rs 5 lakh crores to
comply with Basel III standards. According to global research firm Macquarie, Indian banks
would have to go on a massive capital rising to the extent of over USD 30 billion (INR 1.67 lakh
crores) over the next five years to cater to their growth requirements and Basel-III
implementation charges. Similarly, according to the CARE study too banks have to raise equity
in the range of $45-55 bn to meet BASEL III core equity norms. According to CRISIL, Indian
banks may have to raise a total of about Rs 2.4 trillion to meet growth needs in compliance with
the Reserve Bank of India’s final guidelines on capital adequacy requirements under the new
Basel III norms by March 2018. Although the BASEL III regulations may not put immediate
stress on Indian banks to augment capital, an upsurge in credit off-take and market risk portfolios
is expected to give rise to an increase in the requirement of common equity.
3.4 NARSIMHAM COMMITTEE & ACTION TAKEN:
Measures to Strengthen the Banking System & Capital
The Committee suggests that pending the emergence of markets in India where market
risks can be covered, it would be desirable that capital adequacy requirements take into
account market risks in addition to the credit risks.
Action Taken - Banks are now required to assign capital for market risk. A risk weight of 2.5%
for market risk has been introduced on investments in Govt. and other approved securities with
effect from the year ending 31st March, 2000. For investments in securities outside SLR, a risk
weight of 2.5% for market risk has been introduced with effect from the year ending 31st March,
2001.
In the next three years, the entire portfolio of Government securities should be marked to
market and this schedule of adjustment should be announced at the earliest. It would be
appropriate that there should be a 5% weight for market risk for Govt. and approved
securities.
49
Action Taken - The percentage of banks’ portfolio of Govt. and approved securities which is
required to be marked to market has progressively been increased. For the year ending 31st
March, 2000, banks were required to mark to market 75% of their investments. In order to align
the Indian accounting standards with the international best practices and taking into
consideration the evolving international developments, the norms for classification and valuation
of investments have been modified with effect from September 30, 2000. The entire investment
portfolio of banks is required to be classified under three categories, viz., Held to Maturity,
Available for Sale and Held for Trading. While the securities ‘Held for Trading’ and ‘Available
for Sale’ should be marked to market periodically, the securities ‘Held to Maturity’, which
should not exceed 25% of total investments are carried at acquisition cost unless it is more than
the face value, in which case, the premium should be amortized over a period of time.
The risk weight for a Government guaranteed advance should be the same as for other
advances. To ensure that banks do not suddenly face difficulties in meeting the capital
adequacy requirement, the new prescription on risk weight for Government guaranteed
advances should be made prospective from the time the new prescription is put in place.
Action Taken - In cases of Govt. guaranteed advances, where the guarantee has been invoked
and the concerned State Govt. has remained in default as on March 31, 2000, a risk weight of
20% on such advances, has been introduced. State Govts, Who continue to be in default in
respect of such invoked guarantees even after March 31, 2001, a risk weight of 100%, is being
assigned.
There is an additional capital requirement of 5% of the foreign exchange open position
limit. Such risks should be integrated into the calculation of risk weighted assets. The
Committee recommends that the foreign exchange open position limits should carry a
100% risk weight.
Action Taken - Risk weight of 100% has been introduced for foreign exchange open position
limits with effect from March 31, 1999.
The Committee believes that it would be appropriate to go beyond the earlier norms and
set new and higher norms for capital adequacy. The Committee accordingly recommends
that the minimum capital to risk assets ratio be increased to 10% from its present level of
8%. It would be appropriate to phase the increase as was done on the previous occasion.
Accordingly, the Committee recommends that an intermediate minimum target of 9% be
achieved by the year 2000 and the ratio of 10% by 2002. The RBI should also have the
authority to raise this further in respect of individual banks if in its judgments the
situation with respect to their risk profile warrants such an increase. The issue of
individual banks' shortfalls in the CRAR needs to be addressed in much the same way
that the discipline of reserve requirements is now applied, viz., of uniformity across weak
and strong banks.
Action Taken - The minimum capital to risk asset ratio (CRAR) for banks has been enhanced to
9% with effect from the year ending March 31, 2000.
In respect of PSBs, the additional capital requirement will have to come from either the
Govt. or the market. With the many demands on the budget and the continuing imperative
need for fiscal consolidation, subscription to bank capital funds cannot be regarded as a
50
priority claim on budgetary resources. Those banks which are in a position to access the
capital market at home or abroad should, therefore, be encouraged to do so.
Action Taken - Banks are permitted to access the capital market. Till today, 12 banks have
already accessed capital market.
Asset Quality, NPAs and Directed Credit
The Committee recommends that an asset be classified as doubtful if it is in the
substandard category for 18 months in the first instance and eventually for 12 months and
loss if it has been so identified but not written off. These norms, which should be
regarded as the minimum, may be brought into force in a phased manner.
Action Taken - Banks have been advised that an asset will be classified as ‘doubtful’ if it has
remained in the substandard category for 18 months instead of 24 months as at present, by March
31, 2001. Banks have been permitted to achieve these norms for additional provisioning in
phases, as under : As on 31.3.2001 Provisioning of not less than 50% on the assets which have
become doubtful on account of the new norm. As on 31.3.2002 Balance of the provisions not
made during the previous year, in addition to the provisions needed as on 31.3.2002.
The Committee has noted that NPA figures do not include advances covered by
Government guarantees which have turned sticky and which in the absence of such
guarantees would have been classified as NPAs. The Committee is of the view that for
the purposes of evaluating the quality of asset portfolio such advances should be treated
as NPAs. If , however, for reason of the sovereign guarantee argument such advances are
excluded from computation, the Committee would recommend that Government
guaranteed advances which otherwise would have been classified as NPAs should be
separately shown as an aspect of fuller disclosure and greater transparency of operations.
Action Taken - Prudential norms in respect of advances guaranteed by State Governments where
guarantee has been invoked and has remained in default for more than two quarters has been
introduced in respect of advances sanctioned against State Government guarantee with effect
from April 1, 2000. Banks have been advised to make provisions for advances guaranteed by
State Governments which stood invoked as on March 31, 2000, in phases, during the financial
years ending March 31, 2000 to March 31, 2003 with a minimum of 25% each year.
Banks and financial institutions should avoid the practice of "ever greening" by making
fresh advances to their troubled constituents only with a view to settling interest dues and
avoiding classification of the loans in question as NPAs. The Committee notes that the
regulatory and supervisory authorities are paying particular attention to such breaches in
the adherence to the spirit of the NPA definitions and are taking appropriate corrective
action. At the same time, it is necessary to resist the suggestions made from time to time
for a relaxation of the definition of NPAs and the norms in this regard.
Action Taken - The RBI has reiterated that banks and financial institutions should adhere to the
prudential norms on asset classification, provisioning, etc. and avoid the practice of “ever
greening”.
The Committee believes that the objective should be to reduce the average level of net
NPAs for all banks to below 5% by the year 2000 and to 3% by 2002. For those banks
51
with an international presence the minimum objective should be to reduce gross NPAs to
5% and 3% by the year 2000 and 2002, respectively, and net NPAs to 3% and 0% by
these dates. These targets cannot be achieved in the absence of measures to tackle the
problem of backlog of NPAs on a one time basis and the implementation of strict
prudential norms and management efficiency to prevent the recurrence of this problem.
Action Taken - This is the long-term objective which RBI wants to pursue. Towards this
direction, a number of measures have been taken to arrest the growth of NPAs: banks have been
advised to tone up their credit risk management systems; put in place a loan review mechanism
to ensure that advances, particularly large advances are monitored on an on-going basis so that
signals of weaknesses are detected and corrective action taken early; enhance credit appraisal
skills of their staff, etc. In order to ensure recovery of the stock of NPAs, guidelines for one-time
settlement have been issued in July, 2000.
The Committee is of the firm view that in any effort at financial restructuring in the form
of hiving off the NPA portfolio from the books of the banks or measures to mitigate the
impact of a high level of NPAs must go hand in hand with operational restructuring.
Cleaning up the balance sheets of banks would thus make sense only if simultaneously
steps were taken to prevent or limit the re-emergence of new NPAs which could only
come about through a strict application of prudential norms and managerial improvement.
Action Taken - Banks have been advised to take effective steps for reduction of NPAs and also
put in place risk management systems and practices to prevent re-emergence of fresh NPAs.
For banks with a high NPA portfolio, the Committee suggests consideration of two
alternative approaches to the problem as an alternative to the ARF proposal made by the
earlier CFS. In the first approach, all loan assets in the doubtful and loss categories,
which in any case represent bulk of the hard core NPAs in most banks, should be
identified and their realizable value determined. These assets could be transferred to an
Asset Reconstruction Company (ARC) which would issue to the banks NPA Swap Bonds
representing the realizable value of the assets transferred, provided the stamp duties are
not excessive. The ARC could be set up by one bank or a set of banks or even in the
private sector. In case the banks themselves decide to set up an ARC, it would need to be
ensured that the staff required by the ARC is made available to it by the banks concerned
either on transfer or on deputation basis, so that staff with institutional memory on NPAs
is available to ARC and there is also some rationalization of staff in the banks whose
assets are sought to be transferred to the ARC. Funding of such an ARC could be
facilitated by treating it on par with venture capital for purpose of tax incentives. Some
other banks may be willing to fund such assets in effect by securitizing them. This
approach would be worthwhile and workable if stamp duty rates are minimal and tax
incentives are provided to the banks.
Action Taken - The proposal to set up an Asset Reconstruction Company (ARC) on a pilot basis
to take over the NPAs of the three weak public sector banks, has been announced in the Union
Budget for 1999 – 2000. The modalities for setting up the ARC are being examined.
An alternative approach could be to enable the banks in difficulty to issue bonds which
could form part of Tier II capital. This will help the banks to bolster capital adequacy
which has been eroded because of the provisioning requirements for NPAs. As the banks
52
in difficulty may find it difficult to attract subscribers to bonds. Government will need to
guarantee these instruments which would then make them eligible for SLR investments
by banks and approve instruments by LIC, GIC and Provident Funds.
Action Taken - Banks are permitted to issue bonds for augmenting their Tier II capital.
Guarantee of the Govt. for these bonds is not considered necessary.
Directed credit has a proportionately higher share in NPA portfolio of banks and has been
one of the factors in erosion in the quality of bank assets. There is continuing need for
banks to extend credit to agriculture and small scale sector which are important segments
of the national economy, on commercial considerations and on the basis of
creditworthiness. In this process, there is scope for correcting the distortions arising out
of directed credit and its impact on banks’ assets quality.
Action Taken - The loans to agricultural and SSI sectors are now generally being granted on
commercial considerations and on the basis of creditworthiness of the borrower. Further, the
concessionality on interest rates for advances has been done away with, except for advances
under the DRI Scheme. While advances upto Rs.2 lakh should carry interest rate not exceeding
PLR, interest rates on advances of over Rs.2 lakh have been freed.
The Committee has noted the reasons why the Government could not accept the
recommendation for reducing the scope of directed credit under priority sector from 40%
to 10%. The Committee recognizes that the small and marginal farmers and the tiny
sector of industry and small businesses have problems with regard to obtaining credit and
some earmarking may be necessary for this sector. Under the present dispensation, within
the priority sector 10% of net bank credit is earmarked for lending to weaker sections. A
major portion of this lending is on account of Government sponsored poverty alleviation
and employment generation schemes. The Committee recommends that given the special
needs of this sector, the current practice may continue. The Branch Managers of banks
should, however, be fully responsible for the identification of beneficiaries under the
Government sponsored credit linked schemes. The Committee proposes that given the
importance and needs of employment oriented sectors like food processing and related
service activities in agriculture, fisheries, poultry and dairying, these sectors should also
be covered under the scope of priority sector lending. The Committee recommends that
the interest subsidy element in credit for the priority sector should be totally eliminated
and even interest rates on loans under Rs.2 lakh should be deregulated for scheduled
commercial banks as has been done in the case of Regional Rural Banks and co-operative
credit institutions. The Committee believes that it is the timely and adequate availability
of credit rather than its cost which is material for the intended beneficiaries. The
reduction of the preempted portion of banks' resources through the SLR and CRR would,
in any case, enlarge the ability of banks to dispense credit to these sectors.
Action Taken - As per the present stipulation, banks are required to lend 10% of net bank credit
(NBC) for weaker sections which includes all small and marginal farmers, all IRDP and DRI
borrowers, borrowers under SUME etc. The Committee has recommended that the present
stipulation may continue. As recommended by the Committee, some activities like food
processing, related service activities in agriculture, fisheries, poultry, dairying have been brought
under priority sector. Under the existing dispensation, Units in sectors like food processing, etc.,
satisfying either the definition of SSI [the ceiling of investment in plant and machinery (original
53
cost) for a unit being classified under this category has since been enhanced to Rs. 3 crore from
Rs.60 lakhs / Rs.75 laks for ancillaries and export oriented units] or small business are already
covered under priority sector. No further changes are considered necessary, as larger units need
not be given any advantage by enlarging the scope of definition of priority sector advances. As a
first step towards deregulation of interest rates on credit limits up to R.2 lakh and eliminating
interest subsidy element in credit for priority sector, in the Monetary and Credit Policy
announced in April, 1998, it has been stipulated that interest rates on loans up to Rs.2 lakh
should not exceed PLR as against the earlier stipulation of ‘not exceeding 13.5%’, for credit
limits of Rs.25, 000--Rs.2 lakh and 12% for credit limit up to Rs.25,000. Banks are free to decide
their PLR subject to their obtaining the prior approval of their Boards therefore. As the PLR
differs from bank to bank, depending on their cost of funds and competitive strategies, the
measure is a step towards deregulation of interest rates. Thus the recommendation of the
Committee has been implemented in spirit. It may be stated that except for loans under DRI there
is no subsidization of interest.
Prudential Norms and Disclosure Requirements
With regard to income recognition, in India, income stops accruing when interest or
installment of principal is not paid within 180 days. The Committee believes that we
should move towards international practices in this regard and recommends the
introduction of the norm of 90 days in a phased manner by the year 2002.
Action Taken - The recommendation of the Committee that we should move towards
international practices in regard to income recognition is accepted in principle. However,
tightening of the prudential norms should be made keeping in view the existing legal framework,
production and payment cycles, business practices, the predominant share of agriculture in the
country’s economy, etc. The production and repayment cycles in the industry in the country
generally involve a period of not less than from 4 to 6 months. A large number of SSIs also have
difficulties in timely realization of their bills drawn on the suppliers. These have to be taken into
account while contemplating any change in the norm. Implementation of the recommendation
would have serious implications on the asset portfolio of banks and even good quality borrowers
and find it difficult to comply with the norms recommended. There have been representations
from banks and financial institutions seeking relaxations in the above instructions by increasing
the period to 3-4 quarters. Keeping in view the current industrial scenario, implementation of the
recommendation would have serious implications even to healthy borrowers. Furthermore,
interest on advances is calculated by banks at quarterly rests, keeping in view the large number
and volume of accounts, if we have to implement the recommendation.
At present, there is no requirement in India for a general provision on standard assets. In
the Committee’s view a general provision, say, of 1% would be appropriate and RBI
should consider its introduction in a phased manner.
Action Taken - To start with, a general provision on standard assets of a minimum of 0.25%
from the year ended March 31, 2000 introduced.
There is a need for disclosure, in a phased manner, of the maturity pattern of assets and
liabilities, foreign currency assets and liabilities, movements in provision account and
NPAs. The RBI should direct banks to publish, in addition to financial statements of
independent entities, a consolidated balance sheet to reveal the strength of the group. Full
54
disclosure would also be required of connected lending and lending to sensitive sectors.
Furthermore, it should also ask banks to disclose loans given to related companies in the
bank's balance sheets. Full disclosure of information should not be only a regulatory
requirement. It would be necessary to enable a bank’s creditors, investors and rating
agencies to get a true picture of its functioning – an important requirement in a market
driven financial sector.
Action Taken - Banks have been advised to disclose the following information, in addition to the
existing disclosures, in the ‘Notes on Accounts’ to the balance sheet from the accounting year
ended March 31, 2000.
Maturity pattern of loans and advances,
Maturity pattern of investment securities,
Foreign currency assets and liabilities
Movement in NPAs,
Maturity pattern of deposits
Maturity pattern of borrowings
Lending to sensitive sectors as defined from time to time
Banks should also pay greater attention to asset liability management to avoid
mismatches and to cover, among others, liquidity and interest rate risks.
Action Taken - Detailed guidelines issued to banks on asset –liability management.
Implementation of these guidelines would enable banks to avoid liquidity mismatches as also to
cover, among others, liquidity and interest rate risks.
Banks should be encouraged to adopt statistical risk management techniques like Value-
at-Risk in respect of balance sheet items which are susceptible to market price
fluctuations, forex rate volatility and interest rate changes. While the Reserve Bank may
initially, prescribe certain normative models for market risk management, the ultimate
objective should be that of banks building up their own models and RBI backtesting them
for their validity on a periodical basis.
Action Taken - Comprehensive guidelines have been issued to enable banks to put in place
appropriate risk management systems. Banks have also been advised to adopt statistical risk
management techniques like Value-at-Risk (which is a statistical method of assessing the
potential maximum loss from a credit or investment exposure, over a definite holding period at a
given confidence level) or other models appropriate to their level of business operation.
Systems and Methods in Banks
Banks should bring out revised Operational Manuals and update them regularly, keeping
in view the emerging needs and ensure adherence to the instructions so that these
operations are conducted in the best interest of a bank and with a view to promoting good
customer service. These should form the basic objective of internal control systems, the
major components of which are: (I) Internal Inspection and Audit, including concurrent
audit, (2) Submission of Control Returns by branches/controlling offices to higher level
offices (3) Visits by controlling officials to the field level offices (4) Risk management
systems (5) Simplification of documentation, procedure and of inter office
communication channels.
55
Action Taken - Banks have been advised to bring out revised Operative Manuals and update
them regularly. Banks have confirmed having brought out revised Manuals.
An area requiring close scrutiny in the coming years would be computer audit, in view of
large scale usage and reliance on information technology.
Action Taken - Banks have been advised to set up EDP Audit Cell, as part of their Inspection
Department.
There is enough international experience to show the dangers to an institution arising out
of inadequate reporting to and checking by the back offices of trading transactions and
positions taken. Banks should pay special attention to this aspect.
Action Taken - RBI had in 1992 emphasized to banks the importance of an effective
management reporting system, segregation of the trading and back office functions, etc. The
efficacy of the systems put in place by banks is being constantly reviewed by the RBI through
periodical inspections.
There is need to institute an independent loan review mechanism especially for large
borrowal accounts and systems to identify potential NPAs. It would be desirable that
banks evolve a filtering mechanism by stipulating in-house prudential limits beyond
which exposures on single/group borrowers are taken keeping in view their risk profile as
revealed through credit rating and other relevant factors. Further, in-house limits could be
thought of to limit the concentration of large exposures and industry/sector/geographical
exposures within the Board approved exposure limits and proper overseeing of these by
the senior management/ boards.
Action Taken - Banks have been advised to put in place an independent Loan Review
Mechanism, as recommended by the Committee.
The Committee feels that the present practice of RBI selection of statutory auditors for
banks with Board of Directors having no role in the appointment process, is not
conducive to sound corporate governance. We would recommend that the RBI may
review the existing practice in this regard. It may also reassess the role and function of
the Standing Advisory Committee on Bank Audit in the light of the setting up of the
Audit Committee under the aegis of the Board for Financial Supervision.
Action Taken - The recommendation was put up before the Audit Sub-Committee of the Board
for Financial Supervision which was of the view that the existing practice should continue.
The Committee notes that public sector banks and financial institutions have yet to
introduce a system of recruiting skilled manpower from the open market. The Committee
believes that this delay has had an impact on the competency levels of public sector
banks in some areas and they have consequently lost some ground to foreign banks and
the newly set up private sector banks. The Committee urges that this aspect be given
urgent consideration and in case there is any extant policy driven impediments to
introducing this system, appropriate steps be taken by the authorities towards the needed
deregulation. Banks have to tone up their skills base by resorting, on an ongoing basis, to
lateral induction of experienced and skilled personnel, particularly for quick entry into
new activity/areas. The Committee notes that there has been considerable decline in the
56
scale of merit-based recruitment even at the entry level in many banks. The concept of
direct recruitment itself has been considerably diluted by many PSBs including the State
Bank of India by counting internal promotions to the trainee officers' cadre as direct
recruitment. The Committee would strongly urge the managements of public sector banks
to take steps to reverse this trend. The CFS had recommended that there was no need for
continuing with the Banking Service Recruitment Boards insofar as recruitment of
officers was concerned. This Committee, upon examination of the issue, reaffirms that
recommendation. As for recruitment in the clerical cadre, the Committee recommends
that a beginning be made in this regard by permitting three or four large. well-performing
banks, including State Bank of India, to set up their own recruitment machinery for
recruiting clerical staff. If the experience under this new arrangement proves satisfactory,
it could then pave the way for eventually doing away completely with the Banking
Service Recruitment Boards.
Action Taken - The public sector banks have been permitted to recruit from the open market or
by way of campus recruitment, skilled personnel in areas like information technology, risk
management, treasury operations, etc. As regards the recommendation in regard to discontinuing
the practice of recruitment of officers through Banking Services Recruitment Boards, Govt. may
furnish comments.
It seems apparent that there are varying levels of over manning in public sector banks.
The managements of individual banks must initiate steps to measure what adjustments in
the size of their work force are necessary for the banks to remain efficient, competitive
and viable. Surplus staff, where identified, would need to be redeployed on new business
and activities, where necessary after suitable retraining. It is possible that even after this
some of the excess staff may not be suitable for redeployment on grounds of aptitude and
mobility. It will, therefore, be necessary to introduce an appropriate Voluntary
Retirement Scheme with incentives. The managements of banks would need to initiate
dialogue in this area with representatives of labour.
Action Taken - While some of the public sector banks have introduced VRS after consultations
with Employees’ Unions, others are in the process of introducing such schemes.
The Committee would urge the managements of Indian banks to review the changing
training needs in individual banks keeping in mind their own business environment and
to address these urgently.
Action Taken - Banks have been advised to review the training needs and give more focus to
emerging areas like Credit Management, Treasury Management, Risk Management, Information
Technology, etc.
Structural Issues
The Committee has taken note of the twin phenomena of consolidation and convergence
which the financial system is now experiencing globally. In India also banks and DFIs
are moving closer to each other in the scope of their activities. The Committee is of the
view that with such convergence of activities between banks and DFIs, the DFIs should,
over a period of time, convert themselves to banks. There would then be only two forms
of intermediaries, viz. banking companies and non-banking finance companies. If a DFI
does not acquire a banking license within a stipulated time it would be categorized as a
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non-banking finance company. A DFI which converts to a bank can be given some time
to phase in reserve requirements in respect of its liabilities to bring it on par with the
requirements relating to commercial banks. Similarly, as long as a system of directed
credit is in vogue a formula should be worked out to extend this to DFIs which have
become banks.
Action Taken - Based on the recommendations of the Khan Working Group on Harmonization
of the Role and Operations of banks and DFIs, RBI had released a Discussion Paper in January,
1999 for wider public debate. The feedback on the discussion paper indicated that while
universal banking is desirable from the point of view of efficiency of resource use, there is need
for caution in moving towards such a system by banks and DFIs. Major areas requiring attention
are the status of financial sector reforms, the state of preparedness of concerned institutions, the
evolution of regulatory-regime and above all a viable transition path for institutions which are
desirous of moving in the direction of universal banking. The Monetary and Credit Policy for the
year 2000 –2001 proposed to adopt the following broad approach for considering proposals in
this area:
The principle of “Universal Banking” is a desirable goal and some progress has
already been made by permitting banks to diversify into investments and long-
term financing and the DFIs to lend for working capital, etc. However, banks have
certain special characteristics and as such any dilution of RBI’s prudential and
supervisory norms for conduct of banking business would be inadvisable. Further,
any conglomerate, in which a bank is present, should be subject to a consolidated
approach to supervision and regulation.
Any DFI, which wishes to do so, should have the option to transform into bank
(which it can exercise), provided the prudential norms as applicable to banks are
fully satisfied. To this end, a DFI would need to prepare a transition path in order
to fully comply with the regulatory requirement of a bank. The DFI concerned
may consult RBI for such transition arrangements. Reserve Bank will consider
such requests on a case by case basis.
Mergers between banks and between banks and DFIs and NBFCs need to be based on
synergies and location and business specific complementarities of the concerned
institutions and must obviously make sound commercial sense. Mergers of public sector
banks should emanate from management of banks with Govt. as the common shareholder
playing a supportive role. Such mergers, however, can be worthwhile if they lead to
rationalization of workforce and branch network; otherwise the mergers of public sector
banks would tie down the managements with operational issues and distract attention
from the real issue. It would be necessary to evolve policies aimed at "rightsizing" and
redeployment of the surplus staff either by way of retraining them and giving them
appropriate alternate employment or by introducing a VRS with appropriate incentives.
This would necessitate the cooperation and understanding of the employees and towards
this direction, managements should initiate discussions with the representatives of staff
and would need to convince their employees about the intrinsic soundness of the idea, the
competitive benefits that would accrue and the scope and potential for employees' own
professional advancement in a larger institution. Mergers should not be seen as a means
58
of bailing out weak banks. Mergers between strong banks/FIs would make for greater
economic and commercial sense and would be a case where the whole is greater than the
sum of its parts and have a "force multiplier effect"
Action Taken - The recommendation has been noted. A nonbanking finance company has since
been permitted to merge with a bank. Two banks in the private sector have also merged based on
synergies and business specific complementarities.
A ‘weak bank’ should be one whose accumulated losses and net NPAs exceed its net
worth or one whose operating profits less its income on recapitalization bonds is negative
for three consecutive years. A case by case examination of the weak banks should be
undertaken to identify those which are potentially revivable with a programme of
financial and operational restructuring. Such banks could be nurtured into healthy units
by slowing down on expansion, eschewing high cost funds/borrowings, judicious
manpower deployment, recovery initiatives, containment of expenditure etc. The future
set up of such banks should also be given due consideration. Merger could be a solution
to the problem of weak banks but only after cleaning up their balance sheets. If there is
no voluntary response to a takeover of these banks, it may be desirable to think in terms
of a Restructuring Commission for such public sector banks for considering other options
including restructuring, merger amalgamation or failing these closures. Such a
Commission could have terms of reference which, inter alia, should include suggestion of
measures to safeguard the interest of depositors and employees and to deal with possible
negative externalities. Weak banks which on a careful examination are not capable of
revival over a period of three years should be referred to the Commission.
Action Taken - In addition to the two definitions for identifying ‘weak’ banks recommended by
the Committee, RBI monitors banks to identify ‘potential weakness’ on the basis of five more
parameters (related to solvency, profitability and earnings) as recommended by the Working
Group on Restructuring of Weak Public Sector Banks (Chairman : Shri M.S.Verma ). In respect
of weak banks, a bank-specific restructuring programme aimed at turning around the bank by
reducing their cost of operation, and improving income levels, has been put in place. The
recommendation for setting up of a Restructuring Commission has not been considered.
However, the Union Budget for 2000 – 2001 has proposed setting up of a Financial
Restructuring Authority for a weak or potentially weak bank.
The policy of licensing new private banks (other than local area banks) may continue.
The startup capital requirements of Rs.100 crore were set in 1993 and these may be
reviewed. The Committee would recommend that there should be well defined criteria
and a transparent mechanism for deciding the ability of promoters to professionally
manage the banks and no category should be excluded on a priori grounds. The question
of a minimum threshold capital for old private banks also deserves attention and mergers
could be one of the options available for reaching the required capital thresholds. The
Committee would also, in this connection, suggest that as long as it is laid down (as now)
that any particular promoter group cannot hold more than 40% of the equity of a bank,
any further restriction of voting rights by limiting it to 10% may be done away with.
Action Taken - The policy of licensing new banks in the private sector has been reviewed by an
in-house Working Group set up by RBI. Based on the recommendations of the Working Group,
the licensing policy is being revised.
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The Committee is of the view that foreign banks may be allowed to set up subsidiaries or
joint ventures in India. Such subsidiaries or joint ventures should be treated on par with
other private banks and subject to the same conditions with regard to branches and
directed credit as these banks.
Action Taken - The recommendation has been examined. It has been felt that branch presence by
foreign banks would be better for the reason that the parent bank would stand ready to support
the branch in times of distress. Since subsidiaries would be set up as a joint stock companies with
limited liability, the parent bank’s liability to its subsidiary would be limited to its shareholding.
In the case of branches, the parent bank has responsibility both towards capital and management
whereas in the case of subsidiaries, the parent bank’s responsibility towards capital is limited.
All NBFCs are statutorily required to have a minimum net worth of Rs.25 lakhs if they
are to be registered. The Committee is of the view that this minimum figure should be
progressively enhanced to Rs.2 crores which is permissible now under the statute and that
in the first instance it should be raised to Rs.50 lakhs.
Action Taken - In respect of new NBFCs, which seek registration with the RBI and commence
the business on or after April 20,1999 the criteria in regard to minimum net worth has been
increased to Rs.2 crore, vide the Monetary and Credit Policy for the year 1999-2000.
Deposit insurance for NBFCs could blur the distinction between banks, which are much
more closely regulated, and the non- banks as far as safety of deposit is concerned and
consequently lead to a serious moral hazard problem and adverse portfolio selection. The
Committee would advise against any insurance of deposits with NBFCs.
Action Taken - The recommendation on not providing insurance cover for deposits with NBFCs
has been noted.
RBI should undertake a review of the current entry norms for urban cooperative banks
and prescribe revised prudent minimum capital norms for these banks. Though
cooperation is a state subject, since UCBs are primarily credit institutions meant to be run
on commercial lines, the Committee recommends that this duality in control should be
dispensed with. It should be primarily the task of the Board of Financial Supervision to
set up regulatory standards for Urban Cooperative Banks and ensure compliance with
these standards through the instrumentality of supervision.
Action Taken - The norms with regard to minimum capital requirements for urban cooperative
banks (UCBs) have been revised with effect from 1st April, 1998. Implementation of this
recommendation on doing away with duality of control over UCBs would involve amendments
to State Cooperative Societies Acts. The Government therefore, has to consider.
The Committee is of the view that there is need for a reform of the deposit insurance
scheme. In India, deposits are insured upto Rs.1 lakh. There is no need to increase the
amount further. There is, however, need to shift away from the 'flat' rate premiums to
'risk based' or 'variable rate' premiums. Under risk based premium system all banks
would not be charged a uniform premium. While there can be a minimum flat rate which
will have to be paid by all banks on all their customer deposits, institutions which have
riskier portfolios or which have lower ratings should pay higher premium. There would
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thus be a graded premium. As the Reserve Bank is now awarding CAMELS ratings to
banks, these ratings could form the basis for charging deposit insurance premium.
Action Taken - This has been accepted for implementation. The Working Group on Deposit
Insurance appointed by RBI has recommended the modalities for switching over to ‘risk based’
premium for deposit insurance and the recommendations are under examination.
The Committee is of the view that the inter-bank call and notice money market and inter-
bank term money market should be strictly restricted to banks. The only exception should
be the primary dealers who, in a sense, perform a key function of equilibrating the call
money market and are formally treated as banks for the purpose of their inter-bank
transactions. All the other present non-bank participants in the interbank call money
market should not be provided access to the inter-bank call money market. These
institutions could be provided access to the money market through different segments.
Action Taken - The phasing out of non-bank participants from inter-bank Call/Notice Money
market will be synchronized with the development of repo market. Keeping in view this
objective, RBI has widened the scope of repo market to include all entities having SGL Account
and Current Account in Mumbai, thus increasing the number of eligible non-bank entities to 64.
Further, the permission given to non-bank entities to lend in the call/notice money market by
routing their operations through PDs has been extended upto June, 2001. RBI aims to move
towards a pure interbank (including PDs) call/notice money market. With a view to further
deepening the money market and enable banks, PDs and AIFIs to hedge interest rate risk, these
entities are allowed to undertake FRA/IRSs as a product for their own balance sheet management
and for market making purposes. Mutual Funds, in addition to corporate are also permitted to
undertake FRAs/IRSs with these players. This measure is, inter alia, expected to help
development of a term money market.
There must be clearly defined prudent limits beyond which banks should not be allowed
to rely on the call money market. This would reduce the problem of vulnerability of
chronic borrowers. Access to the call market should be essentially for meeting unforeseen
swings and not as a regular means of financing banks’ lending operations.
Action Taken - RBI has advised banks to put in place comprehensive ALM System with effect
from 1.4.1999. ALM would effectively put a cap on reliance on call money market.
The RBI support to the market should be through a Liquidity Adjustment Facility under
which the RBI would periodically, if necessary daily reset its Repo and Reverse Repo
rates which would in a sense provide a reasonable corridor for market play. While there is
much merit in an inter-bank reference rate like a LIBOR, such a reference rate would
emerge as banks implement sound liquidity management facilities and the other
suggestions made above are implemented. Such a rate cannot be anointed, as it has to
earn its position in the market by being a fairly stable rate which signals small discrete
interest rate changes to the rest of the system.
Action Taken - The ILAF (Interim Liquidity Adjustment Facility) introduced earlier has served
its purpose as a transitional measure for providing reasonable access to liquid funds at set rates of
interest. In view of the experience gained in operating the interim scheme last year, an Internal
Group was set up by RBI to consider further steps to be taken. Following the recommendation of
the Internal Group, it was announced in the Monetary and Credit Policy Measures in April, 2000
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to proceed with the implementation of a full-fledged LAF. The new scheme will be introduced
progressively in convenient stages in order to ensure smooth transition.
In the first stage, with effect from June 5, 2000, the Additional CLF and level II
support to PDs will be replaced by variable rate repo auctions with same day
settlement.
In the second stage, the effective date for which will be decided in consultation
with banks and PDs, CLF and level I liquidity support will also be replaced by
variable rate repo auctions. Some minimum liquidity support to PDs will be
continued but at interest rate linked to variable rate in the daily repos auctions as
determined by RBI from time to time.
With full computerization of Public Debt Office (PDO) and introduction of RTGS
expected to be in place by the end of the current year, in the third stage, repo
operations through electronic transfers will be introduced. In the final stage, it will
be possible to operate LAF at different timings of the same day.
The minimum period of FD be reduced to 15 days and all money market instruments
should likewise have a similar reduced minimum duration
Action Taken -The minimum maturity of CDs has been reduced to 15 days
Foreign institutional investors should be given access to the Treasury bill market.
Broadening the market by increasing the participants would provide depth to the market.
Action Taken -FIIs have been permitted to invest in Treasury Bills, vide Monetary and Credit
Policy announced in April 1998.
With the progressive expansion of the forward exchange market, there should be an
endeavour to integrate the forward exchange market with the spot forex market by
allowing all participants in the spot forex market to participate in the forward market upto
their exposures. Furthermore, the forex market, the money market and the securities
should be allowed to integrate and the forward premia should reflect the interest rate
differential. As instruments move in tandem in these markets the desiderative of a
seamless and vibrant financial market would hopefully emerge.
Action Taken -With effect from June 11, 1998 Foreign Institutional investors were permitted to
take forward cover from Authorized Dealers to the extent of 15 per cent of their existing
investment as on that date. Any incremental investment over the level prevailing on June 11,
1998 was also made eligible for forward cover. The Monetary and Credit Policy for 1999-2000
has further simplified the procedure by linking the above mentioned limits to FIIs’ outstanding
investments as on March 31, 1999. In other words, 15 per cent of outstanding investment on
March 31, 1999 as well as the entire amount – 100 per cent - of any additional investment made
after this date will be eligible for forward cover. Further, any FII which has exhausted the limits
mentioned above can apply to RBI for additional forward cover for a further 15 percent of their
outstanding investments in India at the end of March 1999.
Rural and Small Industrial Credit
The Committee also recommends that a distinction be made between NPAs arising out of
client specific and institution specific reasons and general (agro-climatic and
environmental issues) factors. While there should be no concession in treatment of NPAs
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arising from client specific reasons, any decision to declare a particular crop or product or
a particular region to be distress hit should be taken purely on techno economic
consideration by a technical body like NABARD.
Action Taken -In the event of adverse agro-climatic and environmental factors, covering all
natural calamities, outstanding loans are converted/rescheduled/rephrased suitably. Agricultural
advances so rescheduled are provided relief for NPA classification. The decision to declare a
particular crop or product or a particular region as distress hit is at present vested in the
concerned District Administration Authority and the desirability of consulting NABARD which
is the technical body, before taking the decision, would be examined.
As a measure of improving the efficiency and imparting a measure of flexibility the
committee recommends consideration of the debt securitization concept within the
priority sector. This could enable banks, which are not able to reach the priority sector
target to purchase the debt from the institutions, which are able to lend beyond their
mandated percentage.
Action Taken -The recommendation of the Committee, which basically aims at ensuring that the
target for priority sector lending is achieved by each of the banks, has been re-examined. As of
March 2000, all public sector banks with the exception of UCO Bank have achieved the priority
sector lending target individually and the public sector banks as a Group has exceeded the target
at the macro level. The UCO Bank is short of achievement only marginally. Furthermore, every
year the Govt. has been settings up a Rural Infrastructure Development Fund (RIDF) in which all
banks which do not achieve the priority sector target contribute the amount of shortfall. Thus all
banks, directly or indirectly are able to fulfill the priority sector lending targets. Though the
concept of debt securitization is a novel idea, it will not have any practical application since it
will not help in augmenting the flow of credit to the priority sector nor will it help in addressing
the question of regional imbalances. It has, therefore, been decided that the recommendation
need not be considered for the present.
Banking policy should facilitate the evolution and growth of micro credit institutions
including LABs which focus on agriculture, tiny and small scale industries promoted by
NGOs for meeting the banking needs of the poor. Third-tier banks should be promoted
and strengthened to be autonomous, vibrant, effective and competitive in their operations.
Action Taken -In principle approval has been granted for setting up of 10 Local Area Banks
(LABs). Out of these, on account of non-compliance with the terms and conditions, the ‘in
principle’ approvals given to 4 banks were withdrawn. Of the remaining, 4 LABs have already
started functioning after obtaining licenses under Section 22 of Banking Regulation Act, 1949.
Banks should devise appropriate criteria suited to the small industrial sector and be
responsive to its genuine credit needs but this should not be by sacrificing cannons of
sound banking. Borrowers also need to accept credit discipline. There is also need to
review the present institutional set up of state level financial/industrial development
institutions.
Action Taken -48 recommendations of the S.L. Kapur Committee conveyed to banks for
implementation. As a further impetus to the flow of credit, banks have been advised that the
credit requirement of SSIs having credit limits upto Rs.5 crore, instead of Rs.4 crore, may be
assessed on the basis of 20% of the projected annual turnover.
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Regulations and Supervisions
The Committee recommends that to improve the soundness and stability of the Indian
banking system, the regulatory authorities should make it obligatory for banks to take
into account risk weights for market risks. The movement towards greater market
discipline in a sense would transform the relationship between banks and the regulator.
By requiring greater internal controls, transparency and market discipline, the supervisory
burden itself would be relatively lighter.
Action Taken -Banks are now required to assign capital for market risk. The disclosure
requirements of banks have been strengthened.
There is a need for all market participants to take note of the core principles and to
formally announce full accession to these principles and their full and effective
implementation.
Action Taken -We have endorsed the ‘Core Principles for Effective Banking Supervision’ and
complied with almost all of them. Our compliance with the Core Principles has been rated as
satisfactory by IMF Mission.
Proprietorial concerns in the case of public sector banks impact on the regulatory
function leading to a situation of ‘regulatory capture’ affecting the quality of regulation.
Action Taken -The prudential / regulatory norms stipulated by RBI are applicable to public
sector banks, private sector banks and foreign banks uniformly.
The Committee recommends that the regulatory and supervisory authorities should take
note of the developments taking place elsewhere in the area of devising effective
regulatory norms and to apply them in India taking into account the special
characteristics but not in any way diluting the rigor of the norms so that the prescriptions
match the best practices abroad. It is equally important to recognize that pleas for
regulatory forbearance such as waiving adherence to the regulations to enable some
(weak) banks more time to overcome their deficiencies could only compound their
problems for the future and further emasculate their balance sheets.
Action Taken -The Regulatory / Supervisory norms have been formulated taking into account
the best international practices. RBI has not waived adherence to the regulatory norms by any
individual bank or category of banks.
An important aspect of regulatory concern should be ensuring transparency and
credibility particularly as we move into a more market driven system where the market
should be enabled to form its judgments about the soundness of an institution. There
should be punitive penalties both for the inaccurate reporting to the supervisor or
inaccurate disclosures to the public and transgressions in spirit of the regulations.
Action Taken -We are moving towards greater transparency and Statutory Auditors of banks are
now under the obligation to report on the deviations from adherence to the prudential norms
prescribed by RBI in their ‘Notes to Accounts’. These observations are followed up by the RBI
with the concerned banks. In terms of the provisions of Section 47A of the B.R. Act, 1949, as
amended in 1994, the RBI can impose a penalty not exceeding Rs. 5 lakh or twice the amount
involved in such contravention or default where such amount is quantifiable whichever is more
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and where such contravention or default is a continuing one, a further penalty which may extent
to Rs.25000 for every day after the first day when the contravention or default continues.
The Committee recommends that an integrated system of regulation and supervision be
put in place to regulate and supervise the activities of banks, financial institutions and
non banking finance companies (NBFCs). The functions of regulation and supervision
are organically linked and we propose that this agency be renamed as the Board for
Financial Regulation and Supervision (BFRS) to make this combination of functions
explicit. An independent regulatory supervisory system which provides for a closely
coordinated monetary policy and banking supervision would be the ideal to work
towards.
Action Taken -BFS needs to be strengthened before regulatory functions are vested with it. It
was, therefore, felt that while the Committee’s recommendations to set up an agency named
Board for Financial Regulation and Supervision (BFRS) to provide an integrated system of
regulation and supervision over banks, FIs and NBFCs could be a long term objective. For the
time being, BFS may continue with its present mandate.
Legal and Legislative Framework
With the advent of computerization there is need for clarity in the law regarding the
evidentiary value of computer generated documents. The Shere Committee had made
some recommendations in this regard and the Committee notes that the Government is
having consultations with public sector banks in this matter. With electronic funds
transfer several issues regarding authentication of payment instruments, etc. require to be
clarified. The Committee recommends that a group be constituted by the Reserve Bank to
work out the detailed proposals in this regard and implement them in a time bound
manner.
Action Taken -The Group set up by the RBI has submitted its Report and the recommendations
are in various stages of implementation.
Although there is a provision in our legislation effectively prohibiting loans by banks to
companies in which their directors are interested as directors or employees of the latter
with liberalization and the emergence of more banks on the scene and with the induction
of private capital through public issue in some of the nationalized banks there is a
possibility that the phenomenon of connected lending might reappear even while
adhering to the letter of law. It is necessary to have prudential norms which are addressed
to this problem by stipulating concentration ratios in terms of which no bank can have
more than a specified proportion of its net worth by way of lending to any single
industrial concern and a higher percentage in respect of lending to an industrial group. At
present, lending to any single concern is limited to 25% of a bank’s capital and free
reserves. This would seem to be appropriate along with the existing enhanced figure of
50% for group exposure except in the case of specified infrastructure projects. Similarly,
concentration ratios would need to be indicated, even if not specifically prescribed, in
respect of any bank’s exposure to any particular industrial sector so that in the event of
cyclical or other changes in the industrial situation, banks have an element of protection
from over exposure in that sector. Prudential norms would also need to be set by way of
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prescription of exposure limits to sectors particularly sensitive to asset price fluctuations
such as stock markets and real estate. As it happens, Indian banks do not have much
exposure to the real estate sector in the form of lending for property development as
distinct from making housing loans. The example of banks in East and South East Asia
which had over extended themselves to these two sectors has only confirmed the need for
circumspection in this regard. We would leave the precise stipulation of these limits and,
if necessary, loan to collateral value ratios to the authorities concerned. The
implementation of these exposure limits would need to be carefully monitored to see that
they are effectively implemented and not circumvented, as has sometimes happened
abroad, in a variety of ways. Another salutary prescription would be to require full
disclosure of connected lending and lending to sensitive sectors.
Action Taken -As the Committee has noted, Section 20 of the Banking Regulation Act, 1949
prohibits banks from entering into any commitment for granting of any loan or advance to or on
behalf of any of its directors, any firm in which any of its directors is interested as partner,
manager, employee or guarantor or any company of which any of the directors of the banking
company is a director, managing agent, manager, employee, or guarantor or in which he holds
substantial interest or, any individual in respect of whom any of its directors is a partner or
guarantor. The RBI has, as noted by the Committee, laid down prudential ceilings on exposures
to single / group of borrowers. Banks on their own, have also prescribed exposure ceilings on
single borrower and group of borrowers. As regards the recommendation that prudential norms
be set by way of prescription of exposure limits to sensitive sectors, i.e. those sectors where asset
prices are subject to fluctuations, RBI has already put in place a cap on a bank’s exposure to
share market. The banks on their own have limited their exposure to real estate business. Banks
are expected to set norms for lending to any particular industrial sector in their lending policy.
Banks have been advised to disclose in ‘Notes on Account’ to their balance sheets, lending to
sensitive sectors, (i.e., advances to sectors such as, capital market, real estate, etc.) and such
other sectors to be defined as ‘sensitive’ by RBI from time to time with effect from the year
ended March 31, 2000.
The Committee recommends that the RBI should totally withdraw from the primary
market in 91 days Treasury Bills; the RBI could, of course, have a presence in the
secondary market for 91 days Treasury Bills. If the 91 days Treasury bill rate reflects
money market conditions, the money and securities market would develop an integral
link. ….The Committee also recommends that foreign institutional investors should be
given access to the Treasury bill market.
Action Taken -The withdrawal of RBI from the primary market in 91 day Treasury Bills is the
long term objective. The pace of implementation of the recommendation should depend upon the
development and depth of the Govt. securities market. One of the objectives of evolving the
system of Primary Dealers is to improve the underwriting and market making capabilities in
Government securities market so that RBI could eventually withdraw from primary
subscriptions. This will be possible only when Primary Dealers are capable of taking
devolvement, if any, to the full extent.
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3.5 RAGURAM RAJAN COMMITTEE RECOMMENDATION ANALYSIS:
Macro Economic Framework
India’s economy has become more open and it is impossible to control capital flows in
either direction, except for the very short term. Given this, the real exchange rate, which
is the key factor determining India’s competitiveness, is influenced by factors such as
productivity growth and demand supply imbalances that are not changed by central bank
intervention against the dollar. The RBI should formally have a single objective, to stay
close to a low inflation number, or within a range, in the medium term, and move steadily
to a single instrument, the short-term interest rate (repo and reverse repo) to achieve it.
Steadily open up investment in the rupee corporate and government bond markets to
foreign investors after a clear monetary policy framework is in place. India should accept
the possible costs of subsequent currency appreciation as a legitimate down payment on
the more robust markets and financing we will enjoy in the future. We should also relieve
pressure from inflows by becoming more liberal on outflows, especially in forms that can
be controlled if foreign currency becomes scarce. For instance, we should encourage
greater outward investment by provident funds and insurance companies when inflows
are high.
Broadening Access to Finance
Allow more entry to private well-governed deposit-taking small finance banks offsetting
their higher risk from being geographically focused by requiring higher capital adequacy
norms, a strict prohibition on related party transactions, and lower allowable
concentration norms. The small finance bank proposed emulates the Local Area Bank
initiative by the RBI that was prematurely terminated, though the details of the
Committee’s proposal differs somewhat. The intent is to bring local knowledge to bear on
the products that are needed locally, and to have the locus of decision making close to the
banker who is in touch with the client. This would suggest rethinking the entire
cooperative bank structure, and moving more to the model practiced elsewhere in the
world, where members have their funds at stake and exercise control, debtors do not have
disproportionate power, and government refinance gives way to refinancing by the
market. The Committee would suggest implementation of a strong prompt corrective
action regime so that unviable cooperatives are closed, and would recommend that well-
run cooperatives with a good track record explore conversion to a small bank license,
with members becoming shareholders.
The second organizational structure the Committee proposes makes it easier for large
financial institutions to ‘bridge the last mile’. Large institutions have the ability to offer
commodity products like savings accounts at low cost, provided the cost of delivery and
customer acquisition is reduced. They should be able to use existing networks like cell-
phone kiosks or kirana shops as business correspondents to deliver products. Liberalize
the banking correspondent regulation so that a wide range of local agents can serve to
extend financial services. Use technology both to reduce costs and to limit fraud and
misrepresentation.
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Offer priority sector loan certificates (PSLC) to all entities that lend to eligible categories
in the priority sector. Allow banks that undershoot their priority sector obligations to buy
the PSLC and submit it towards fulfillment of their target. Any registered lender