REFORMS IN THE BANKING SECTOR

Following the introduction of economic reforms in 1991, banking sector reforms were also initiated to up grade the operating standards, health and financial soundness of banks to internationally accepted levels in an increasingly globalized market. The GOI set up the Narasimham Committee in 1991 to examine all aspects relating to the structure, operations and functioning of the Indian banking system. The recommendations of the Committee aimed at creating a competitive and efficient banking system. Measures like capital adequacy, income recognition, asset classification and provisioning norms, entry of private banks, gradual reduction of CRR and SLR were recommended and implemented to strengthen the banking system. These recommendations changed the face of Indian banking system. Public Sector Banks faced a stiff competition from the new private sector banks. Another Committee which deserves mention is the Khan Committee, set up by RBI in December 1997, to examine the role and operations of DFI s (Development Financial Institutions) and banks. The Committee submitted its report in April 1998. The major recommendation of the Committee was a gradual move towards universal banking; exploring the possibility of gainful mergers as between banks & banks and financial institutions; encompassing both strong and weak entities or and two strong ones; developing a function specific regulatory framework and a risk based supervisory framework; establishment of a super regulator to supervise and co ordinate the activities of multiple regulators; speedy implementation of legal reforms to hasten debt recovery; reducing CRR to international standards and phasing out SLR. The Verma Committee, which had been the most controversial of all Committees, recommended the need for greater use of Information Technology, even in the weak public sector banks; restructuring weak banks but not merging them with strong banks; market driven mergers and sale of foreign branches; closure of subsidiaries of weak public sector banks and Voluntary Retirement Scheme (VRS) for at least 25% of the staff. The banking sector reforms aimed at improving the policy framework, financial health, and institutional infrastructure. Improvement in the policy structure has been undertaken by reducing the reserve requirements, changing the administered structure of interest rates, enlarging the scope of

Priority Sector Lending, and linking the lending rates with the size of advances. Efforts have been made to improve the financial health of the banking sector by prescribing prudential norms. Improvement in the institutional framework has been sought through recapitalization, infusing competition and strengthening of the supervisory system. The highlight of the reform process is that the reform measures have been undertaken and implemented gradually and cautiously. The first phase of the banking reforms is complete and the second generation reforms are under way. The second generation reforms are those that did not form a part of the first generation reforms but needed to be prioritized in the agenda for the next decade. Many of the important recommendations of the Nrasimham Committee II have been accepted and are under implementation. The second generation banking reforms concentrate on strengthening the foundation of the banking system by structure, technological up gradation and human resource development. The second generation reforms aim at further strengthening the banking system and move towards international best practices in areas relating to banking policy, institutional, supervisory and legislation.

Banking Sector Reforms PHASE I Recommendations of the Committee on Banking Sector

Reforms (Narasimham Committee I) Deregulation of Interest Rate Structure. Progressive reduction in pre-emptive reserves. Liberalization of the branch expansion policy. Introduction of prudential norms to ensure capital adequacy, proper income recognition, classification of assets based on their quality and provisioning norms for bad and doubtful debts. Decreasing the emphasis laid on directed credit and phasing out the concessional rates of interest rate for priority sector advances. Deregulation of the entry norms for private sector banks and foreign banks. Permitting the public and private sector banks to access the capital market. Setting up of the Asset Reconstruction Fund. Constituting the Special Debt Recovery Tribunals.

Freedom to appoint Chief Executive and other key executives of the banks. Changes in the constitution of the Boards of the banks. Bringing NBFCs under the regulatory framework. PHASE II- Recommendations of the Committee on Banking Sector Reforms (Narasimham Committee II)

Capital Adequacy
1) Capital Adequacy Ratio to be raised from 8% to 10% by 2002. 2) 100% of fixed income portfolio to be marked to market by 2001

(up from 70%). 3) 5% market risk weight for fixed income securities and open foreign exchange position limits (no market risk weights previously). 4) Commercial risk weight of 100% to Government guaranteed advances (previously treated as risk free).

Asset Quality
1) Banks should aim to reduce gross non performing assets to less than 3% and net non performing assets to zero percent by 2002. 2) 90 days over due norm to be applied for cash based income recognition (down from 180 days). 3) Government guaranteed irregular accounts to be classified as non performing assets and provided for. 4) Asset Reconstruction Company to take over NPA s of weak banks against issue of risk-free bonds. 5) Directed credit obligations to be reduced from 40% to 10%. 6) Mandatory provisions of 1% of standard assets and specific provisions to be made tax-deductible.

Systems & Methods

1) Banks to start recruitment of skilled, specialized work force from the

market. 2) Overstaffing to be dealt with by redeployment and right sizing via voluntary retirement schemes. 3) Public sector banks to be given autonomy to fix the remuneration structure in line with the market. 4) Rapid introduction of computerization and technology upgradation.

Industry Structure
1) Only two categories of financial sector players to emerge banks and non bank finance companies. DFI s to convert into banks or remain as NBFCs.

2) Mergers to be driven by market and business considerations, not to be imposed by regulators or Government. 3) Weak banks to convert to narrow banks, restructure or close down if found non viable. 4) Entry of new private banks and foreign banks to continue. 5) Banks to be given greater functional autonomy, and minimum government shareholding to be reduced to 33% from 55% in case of SBI and from 51% in case of nationalized banks.

Regulation & Supervision

Banking Regulation and Supervision to be progressively delinked from monetary policy. 2) Board for Financial Regulation & Supervision to be constituted with statutory powers and Board members to be professionals. 3) Greater emphasis on public disclosure as opposed to disclosure to regulators.
1)

Legal Amendments
1) 2) 3) Broad range of legal reforms to facilitate recovery of problem loans. Introduction of laws governing electronic transfer of funds. Amendments to the Banking Regulation Act, the Nationalization Act and the State Bank of India Act to allow greater autonomy, higher private sector shareholding and so on.

Prudential Regulation
There are two models for bank regulation economic regulation and prudential regulation. Economic regulation calls for imposing constraints on interest rates, tightening of entry norms, and directed lending. In the pre reforms era, the RBI regulated banks through economic regulation model. However the empirical evidences indicated that this model hampered the productivity and efficiency of the banking system. Hence, the RBI switched to the prudential regulation in the post reforms era. Prudential regulatory model calls for imposing the regulatory capital level to maintain the health of banks and the soundness of the financial system. It allows greater play for market forces than economic regulatory model. The RBI issued prudential norms based on the recommendations of the Narasimham Committee Report. The major objective of prudential norms is to ensure financial safety, soundness and solvency of banks. These norms strive to ensure that banks conduct their business activities as prudent business entities and do not indulge in excessive risk taking in pursuit of profits.

Banking reforms were initiated by implementing prudential norms consisting of capital adequacy ratio, income recognition, asset classification and provisioning. The core of financial sector reforms has been the broadening of prudential norms to the best internationally recognized standards.

Capital Adequacy Tier I and Tier II Capital

Banks are required to maintain unimpaired minimum capital funds equivalent to the prescribed ratio on the aggregate of the risk weighted assets and other exposures. Capital Adequacy Ratio is a measure of the banks capital expressed as a percentage of its risk weighted assets and other exposures. The capital framework was introduced for the Indian scheduled commercial banks, based on the Basel Committee proposals (1988), which prescribes two tiers of capital for the banks. Tier I capital, which can absorb losses without a bank being required to cease trading and tier II capital which can absorb losses in the event of a winding up. Tier I or core capital (the most permanent and readily available support against unexpected losses) includes a) paid up capital , statutory reserves and share premium, and b) Capital reserve ( representing surplus on sale of assets and held in a separate account only to be included) and other disclosed free reserve minus equity investments in subsidiaries, intangible assets, loses in the current period, and those brought forward from previous periods. Tier II Capital includes a) Undisclosed reserves and fully paid up cumulative perpetual preference shares. b) Revaluation reserves arising out of revaluation of assets that are undervalued in the banks books (banks premises and marketable securities). c) General provisions and loss reserves, not attributable to the actual diminution in value or identifiable potential loss in any specific asset and available to meet unexpected losses. d) Hybrid debt capital instruments that combine characteristics of equity and debt. e) Subordinated debt that is fully paid up, unsecured , subordinated to the claims of other creditors, free of restrictive clauses, and not redeemable at the initiative of the holder or without the consent of the supervising authority of banks. If subordinated debt carried a fixed maturity, it should be subject

to progressive discount and have an initial maturity of not less than 5 years. Tier II capital should not be more than 100% of Tier I capital, and subordinated debt instruments should be limited to 50% of Tier I capital. Revaluation Reserve should be applied a discount of 35% for inclusion in Tier II capital. General provision / loss reserves should not exceed 1.25% of the total risk weighted assets. Banks will have to disclose any shortfall in capital to their depositors and all stakeholders. In order to provide additional options to banks for raising capital funds, the RBI allowed them in January 2006, to issue instruments such as (i) Innovative Perpetual Debt Instruments eligible to be included as Tier I capital, (ii) debt capital instruments eligible for inclusion as Upper Tier II capital, (iii) perpetual non cumulative preference shares eligible for inclusion as Tier II capital, and (iv) redeemable cumulative preference shares eligible for inclusion as Tier II capital.

Capital Adequacy for Subsidiaries

Banks to voluntarily build in the risk weighted components of their subsidiaries into their own balance sheet on a notional basis, at par with the risk weights applicable to the banks own assets. The additional capital is to be built up in the banks books in phases from M<arch 2001.

Capital Adequacy Norms

Banks capital is vital as it is the lifeblood which keeps the bank alive; it also gives the bank the ability to absorb shocks and thereby avoid the likelihood of bankruptcy. Capital adequacy ratio is a measure of the amount of the banks capital expressed as a percentage of its risk weighted assets and other exposures. The Basel norm of capital adequacy was introduced in India following the recommendations of the Narasimham Committee in 1991. Globally, the structure and operations of banks underwent a rapid transformation in the 1980s due to revolutionary progress in Information Technology which led to intense competition among banks and a pressure on their profit margins. As a result, there was a growing apprehension about the deteriorating level of capital in banks. Hence the Basel capital adequacy norms were enacted in 1988. The Basel Accord of 1988 (Basel Accord I) suggested the following principles of capital adequacy. 1) A bank must hold equity capital of at least 8%of its assets when multiplied by appropriate risk weights. The four risk weights

suggested were 0 percent, 1.6 percent, 4 percent and 8% for various categories of assets. 2) When capital falls below the minimum requirement, shareholders may be permitted to retain control of the bank provided they agree to recapitalize the bank. 3) When this is not done, the regulatory authority may sell or liquidate the bank at its discretion. Initially, the RBI directed the banks to maintain a minimum CAR of 8% of the risk weighted assets. The Committee on banking sector reforms (1998) suggested further tightening of the capital adequacy norms. Hence the CRAR required was raised to 9% to be achieved by March 2000. The concept of CRAR relates to the risk weights assigned to various assets and exposures undertaken by the bank in the course of its business and the proportion of capital to be maintained on such aggregate risk weighted assets and exposures. CRAR is calculated on the basis of risk weighted assets and exposures in the books of the bank. Each business transaction carries a specific risk weight and a portion of capital has to be earmarked for this risk. This acts as a secret cushion against any possible future loss. Higher capital adequacy will drive banks towards greater efficiency and this could force banks to bring down operating costs. Capital Adequacy enables banks to expand their balance sheets and strengthen their fundamentals, which in turn help the banks to raise capital at a reasonable cost. Hence quality and risk weights of assets are the new and important parameters which are crucial for the growth of banks. At present, RBI has stipulated a minimum CRAR of 10% for banks having international operations and 9% for banks having only domestic operations.

The New Basel Capital Accord or Basel Accord II

The Bank for International Settlements (BIS) is an international organization which fosters international monetary and financial co operation and serves as a bank for all central banks. The Basel Committee, consisting of central bank governors of a group of countries, was set up towards the end of 1974 and meets regularly about 4 times in a year. It also has about 30 technical working groups and task forces which also meet regularly. India is a member of the group of 20 countries (G20) that advises the Financial Stability Forum (FSF).The Core Principles Liaison Group set up the Basel Committee on Banking Supervision (BCBS) to promote and monitor principles of banking supervision and the working groups on capital, which discusses the proposals for revising the capital adequacy

framework. India is also an early subscriber to the Special Data Dissemination Standards (SDDS) and one of the first countries to accept the financial sector assessment program of the IMF and the World Bank. Different central banks in their own countries regulate the banks by the rules set by them. International banks had to adhere to different regulations in different countries. To provide a level playing field for banks, the group of 15 most industrialized countries agreed on some common rules which came to be known as Basel Accord. The central banks of more than 100 countries have adopted it over a period of time. The problems in south East Asian countries, the recessionary trends in Japanese economy, the financial sector problems encountered in Latin American countries as also in some European economies emphasized that capital adequacy norms were not adequate to hedge against failures. These norms helped arrest the erosion of the banks capital ratios. However, they were not found to be adequate due to their perceived rigidities. Moreover, the financial markets, financial intermediaries, business of banking, risk management practices and supervisory approaches have undergone significant changes. These baseline capital adequacy norms were found to be inadequate as they almost entirely addressed credit risk. In response to the same, the BCBS brought out their Consultative Paper on New Capital Adequacy Framework in June 1999 and a second revision in January 2001 after an informed public debate. The new rules have been effective from 2005. The BCBS also announced the establishment of an Accord Implementation Group. The primary objectives of the new accord are 1) To promote the safety and soundness of the financial system, 2) The enhancement of competitive equality, and 3) The constitution of a more comprehensive approach to addressing various risks. The New Basel capital Accord is based on three mutually reinforcing pillars that allow banks and supervisors to evaluate properly the various risks that the banks face. The new accord focuses on the following 1) Minimum capital requirements, which seek to define the measurement framework set out in the 1988 accord, 2) Supervisory Review of an institutions capital adequacy and internal assessment process, and 3) Market Discipline through effective disclosure to encourage safe and sound banking practices.

Minimum Capital Requirement

The new framework maintains both the current definition of capital and the minimum requirement of 8% of CRAR. The revised accord will be extended on a consolidation basis to holding companies of banking groups. The accord stresses upon improvement in the measurement of risks. The new accord has elaborated the credit risk measurement methods and emphasized the measurement of operational risks. The Basel II Accord has recommended three approaches the standardized approach, the foundation internal risk based approach (IRB) and the advanced IRB approach for estimating capital charge for credit risk. The standardized approach expands the scale of risk weights and uses external credit ratings to categorize credits. This approach can be employed by the less complex banks. Banks with more advanced risk management capabilities can employ an IRB approach. This approach allows banks to use its internal estimates of a borrowers credit worthiness to assess credit risk in the portfolio subject to strict methodological and disclosure standards. One of the most noteworthy features of Basel II is assigning capital charge for operational risk. Three approaches, namely, basic indicator approach (BIA), Standardized Approach (SA), and Advanced Measurement Approach (AMA) have been recommended for estimating capital for operational risk. Advanced measurement calls for significant investment as compared to the other two approaches.

Supervisory Review Process

This process emphasizes the need for banks to develop sound internal processes to assess the adequacy of capital based on a thorough evaluation of its risks and set commensurate targets for capital. The internal processes would then be subjected to supervisory review and intervention. The supervisors would be responsible for evaluating the way the banks are measuring risks and the robustness of systems and processes. The four basic and complementary principles on which the Pillar II rests are 1) A bank should have a process for assessing its overall capital adequacy based on a thorough evaluation of its risk profile as well as a strategy for maintaining capital levels, 2) Supervisors should review and evaluate a banks internal capital adequacy assessment and strategy as well as its compliance with regulatory capital ratios ,

3) Supervisors expect the banks to operate above the minimum regulatory capital ratios and should have the ability to require the banks to hold capital in excess of the minimum, and 4) Supervisors should seek to intervene at an early stage to prevent capital from dipping below prudential levels. Implementation of Pillar II requires that a comprehensive assessment of risks be carried out by the banks themselves internally and the supervisors externally. A Board for Financial Supervision has been set up with an Advisory Council to strengthen the supervisory system of banks and an independent Department of Banking Supervision has been set up in the RBI to assist the Board.

Market Discipline
Market Discipline can be bolstered through enhanced disclosure by banks. The new framework sets out disclosure requirements in several areas, including the way in which banks calculate their capital adequacy and their risk assessment methods. The transparency and disclosure standards recommended in the International Accounting Standards have been implemented in a phased manner. Banks are required to ensure that there are no qualifications by the auditors in their financial statements for non compliance with any of the accounting standards. Banks are now required to disclose maturity pattern of deposits, borrowings, advances , investments, foreign currency assets and liabilities, movements in NPAs, lending to sensitive sectors, total advances against shares, convertible debentures and equity oriented mutual funds, and movement of provisions held towards depreciation of investments.

Issues in Implementation of Basel II Accord

1) Indian banks still do not fully disclose requirements relating to capital

adequacy, credit risk and market risk. Requirements relating to operational risk and quantitative disclosures on risk management are not made at all. 2) Indian banks will face a stiff competition from foreign banks once Basel II is implemented. Foreign banks by using sophisticated risk management practices will compete not on size but on ability. 3) The capital base of most Indian banks is relatively low. Most banks will need to raise a large amount of funds to meet the regulatory capital, allocation for risk in future, credit growth and upgrading technology systems. 4) Banks will need a new set of human resources with distinct skills and training which will be difficult at the outset. Hence banks will also

require capital resources to invest in training and upgrading the skills of its employees. 5) In India, there are only 4 external rating agencies, which will be insufficient to rate around 100 commercial banks. Moreover banks do not have robust rating systems which could lead banks to loosen their own credit rating models when implementing these standards. 6) Small banks would be at a competitive disadvantage against large banks as they will not have the resources to implement advanced methodologies. Thus, the objective of Basel II to ensure competitive equality will not be achieved. The new accord when implemented could increase the banks reliance on advanced risk management techniques which could lead to further consolidation through mergers and acquisitions. However, developing countries might encounter certain problems, such as increased flow of resources to capital regulation, scarcity of high quality skilled personnel, and increased reliance on external rating agencies, which could lead banks to loosen their own credit rating models when implementing these standards. The advisory groups constituted by RBI have found the level of compliance of international standards by the Indian banking system to be of a high order. The capital of the public sector banks has increased through Government capital infusion, equity issues to the public and retained earnings. The trial runs on select banks on Basel II norms was carried out in April 2006and all banks were expected to adopt the norms by 2007. The RBI issued detailed prudential guidelines for implementation of the new accord in February 2005. The RBI gave more time to the banks to put in place appropriate systems so as to ensure full compliance with Basel II accord. Foreign banks operating in India and Indian banks having presence outside India were asked to migrate to the Standardized Approach for credit risk and the Basic Indicator Approach for operational risk under Basel II by March 31,2008. All other scheduled commercial banks were asked to migrate to these approaches by March 31, 2009.