19075032 indian banking sector reforms

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Reforms in Indian Banking Sector 2011

EXECUTIVE SUMMARY

A retrospect of the events clearly indicates that the Indian banking sector has come far

away from the days of nationalization. The Narasimham Committee laid the foundation

for the reformation of the Indian banking sector. Constituted in 1991, the Committee

submitted two reports, in 1992 and 1998, which laid significant thrust on enhancing

the efficiency and viability of the banking sector. As the international standards

became prevalent, banks had to unlearn their traditional operational methods of

directed credit, directed investments and fixed interest rates, all of which led to

deterioration in the quality of loan portfolios, inadequacy of capital and the erosion of

profitability.

The recent international consensus on preserving the soundness of the banking

system has veered around certain core themes. These are: effective risk management

systems, adequate capital provision, sound practices of supervision and regulation,

transparency of operation, conducive public policy intervention and maintenance of

macroeconomic stability in the economy.

Until recently, the lack of competitiveness vis--vis global standards, low technological

level in operations, over staffing, high NPAs and low levels of motivation had shackled

the performance of the banking industry.

However, the banking sector reforms have provided the necessary platform for the

Indian banks to operate on the basis of operational flexibility and functional autonomy,

thereby enhancing efficiency, productivity and profitability. The reforms also brought

about structural changes in the financial sector and succeeded in easing external

constraints on its operation, i.e. reduction in CRR and SLR reserves, capital adequacy

norms, restructuring and recapitulating banks and enhancing the competitive element

in the market through the entry of new banks.

The reforms also include increase in the number of banks due to the entry of new

private and foreign banks, increase in the transparency of the banks balance sheets

through the introduction of prudential norms and increase in the role of the market

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forces due to the deregulated interest rates. These have significantly affected the

operational environment of the Indian banking sector.

To encourage speedy recovery of Non-performing assets, the Narasimham committee

laid directions to introduce Special Tribunals and also lead to the creation of an Asset

Reconstruction Fund. For revival of weak banks, the Verma Committee

recommendations have laid the foundation. Lastly, to maintain macroeconomic

stability, RBI has introduced the Asset Liability Management System.

The East-Asian crisis has demonstrated the vital importance of financial institutions in

sustaining the momentum of growth and development. It is no longer possible for

developing countries like India to delay the introduction of these reforms of strong

prudential and supervisory norms, in order to make the financial system more

competitive, more transparent and more accountable.

The competitive environment created by financial sector reforms has nonetheless

compelled the banks to gradually adopt modern technology to maintain their market

share. Thus, the declaration of the Voluntary Retirement Scheme accounts for a

positive development reducing the administrative costs of Public Sector banks. The

developments, in general, have an emphasis on service and technology; for the firsttime that Indian public sector banks are being challenged by the foreign banks and

private sector banks.Branch size has been reduced considerably by using technology

thus saving manpower.

The deregulation process has resulted in delivery of innovative financial products at

competitive rates; this has been proved by the increasing divergence of banks in retail

banking for their development and survival.

In order to survive and maintain strong presence, mergers and acquisitions has been

the most common development all around the world. In order to ensure healthy

competition, giving customer the best of the services, the banking sector reforms have

lead to the development of a diversifying portfolio in retail banking, and insurance,

trend of mergers for better stability and also the concept of virtual banking.

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The Narasimham Committee has presented a detailed analysis of various problems

and challenges facing the Indian banking system and made wide-ranging

recommendations for improving and strengthening its functions.

REFORMS IN THE INDIAN BANKING SECTOR

TABLE OF CONTENTS

TITLE

PAGE NO

1.1 Introduction 01

1.2Reduction of SLR and CRR 04

1.3Minimum Capital Adequacy Ratio

07

1.4 Prudential Norms 11

1.5 Disclosure Norms 17

1.6 Rationalisation of Foreign Operations in India

19

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1.7 Special Tribunals and Asset Reconstruction

Fund 23

1.8Restructuring of Weak Banks

26

1.9 Asset Liability Management System

29

1.10 Reduction of Government Stake in PSBs

32

1.11 Deregulation of Interest Rate

39

List of Illustrations and Visual Aids

Illustration

No.

Title Page no.

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1

2

3

4

5

6

Trends in CRR and SLR

Growth In Investments InGovernment Securities by

Banks

Classification of Loan Assetsof SCBs

Indian Banks: Trend in ROE

Capital Contributed byGovernment

Income and Expenses Profileof banks

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20

27

39

61

67

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ChapterNo 01

introduction

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As the real sector reforms began in 1992, the need was felt to restructure

the Indian banking industry. The reform measures necessitated thederegulation of the financial sector, particularly the banking sector. The

initiation of the financial sector reforms brought about a paradigm shift in

the banking industry. In 1991, the RBI had proposed to from the

committee chaired by M. Narasimham, former RBI Governor in order to

review the Financial System viz. aspects relating to the Structure,

Organisations and Functioning of the financial system. The Narasimham

Committee report, submitted to the then finance minister, Manmohan

Singh, on the banking sector reforms highlighted the weaknesses in the

Indian banking system and suggested reform measures based on the

Basle norms. The guidelines that were issued subsequently laid the

foundation for the reformation of Indian banking sector.

The main recommendations of the Committee were: -

i. Reduction of Statutory Liquidity Ratio (SLR) to 25 per cent over a

period of five years

ii. Progressive reduction in Cash Reserve Ratio (CRR)

iii. Phasing out of directed credit programmes and redefinition of the

priority sector

iv. Deregulation of interest rates so as to reflect emerging market

conditions

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1.1 Introduction


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v. Stipulation of minimum capital adequacy ratio of 4 per cent to risk

weighted assets by March 1993, 8 per cent by March 1996, and 8 per

cent by those banks having international operations by March 1994

vi. Adoption of uniform accounting practices in regard to income

recognition, asset classification and provisioning against bad and

doubtful debts

vii. Imparting transparency to bank balance sheets and making more

disclosures

viii. Setting up of special tribunals to speed up the process of recovery of

loansix. Setting up of Asset Reconstruction Funds (ARFs) to take over from

banks a portion of their bad and doubtful advances at a discount

x. Restructuring of the banking system, so as to have 3 or 4 large

banks, which could become international in character, 8 to 10

national banks and local banks confined to specific regions. Rural

banks, including RRBs, confined to rural areas

xi. Abolition of branch licensing

xii. Liberalising the policy with regard to allowing foreign banks to open

offices in India

xiii. Rationalisation of foreign operations of Indian banks

xiv. Giving freedom to individual banks to recruit officers

xv. Inspection by supervisory authorities based essentially on the

internal audit and inspection reports

xvi. Ending duality of control over banking system by Banking Division

and RBI

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xvii. A separate authority for supervision of banks and financial

institutions which would be a semi-autonomous body under RBI

xviii. Revised procedure for selection of Chief Executives and Directors of

Boards of public sector banks

xix. Obtaining resources from the market on competitive terms by DFIs

xx. Speedy liberalisation of capital market

xxi. Supervision of merchant banks, mutual funds, leasing companies

etc., by a separate agency to be set up by RBI and enactment of a

separate legislation providing appropriate legal framework for mutual

funds and laying down prudential norms for such institutions, etc.

Several recommendations have been accepted and are being

implemented in a phased manner. Among these are the reductions in

SLR/CRR, adoption of prudential norms for asset classification and

provisions, introduction of capital adequacy norms, and deregulation of

most of the interest rates, allowing entry to new entrants in private sector

banking sector, etc.

Keeping in view the need of further liberalisation the Narasimham

Committee II on Banking Sector reform was set up in 1997. This

committees terms of reference included review of progress in reforms in

the banking sector over the past six years, charting of a programme of

banking sector reforms required to make the Indian banking system more

robust and internationally competitive and framing of detailed

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recommendations in regard to make the Indian banking system more

robust and internationally competitive.

This committee constituted submitted its report in April 1998. The major

recommendations are :

i. Capital adequacy requirements should take into account market risks

also

ii. In the next three years, entire portfolio of Govt. securities should be

marked to market

iii.Risk weight for a Govt. guaranteed account must be 100 percent

iv.CAR to be raised to 10% from the present 8%; 9% by 2000 and 10%

by 2002

v. An asset should be classified as doubtful if it is in the sub-standard

category for 18 months instead of the present 24 months

vi.Banks should avoid ever greening of their advances

vii. There should be no further re-capitalization by the Govt.

viii. NPA level should be brought down to 5% by 2000 and 3% by 2002.

ix.Banks having high NPA should transfer their doubtful and loss

categories to ARCs which would issue Govt. bonds representing the

realisable value of the assets.

x. International practice of income recognition by introduction of the

90-day norm instead of the present 180 days.xi.A provision of 1% on standard assets is required.

xii. Govt. guaranteed accounts must also be categorized as NPAs

under the usual norms

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xiii. There is need to institute an independent loan review mechanism

especially for large borrowal accounts to identify potential NPAs.

xiv. Recruitment of skilled manpower directly from the market be

given urgent consideration

xv. To rationalize staff strengths, an appropriate VRS must be

introduced.

xvi. 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 recap bonds is negative for 3 consecutive years.

To start with, it has assigned a 2.5 per cent risk-weightage on gilts by

March 31, 2000 and laid down rules for provisioning; shortened the life of

sub-standard assets from 24 months to 18 months (by March 31, 2001);

called for 0.25 per cent provisioning on standard assets (from fiscal 2000);

100 per cent risk weightage on foreign exchange (March 31, 1999) and a

minimum capital adequacy ratio of 9 per cent as on March 31, 2000.

Only a few of these mainly constitute to the reforms in the banking sector.

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ChapterNo 02

Reduction

Ofslr and crr

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The South East Asian countries introduced banking reforms wherein bank

CRR and SLR was reduced, this increased the lending capacity of banks. The markets fell precipitously because banks and corporates did not

accurately measure the risk spread that should have been reflected in

their lending activities. Nor did they manage such risks or provide for

them in their balance sheets. And followed the South East Asian Crisis.

The monetary policy perspective essentially looks at SLR and CRR

requirements (especially CRR) in the light of several other roles they play

in the economy. The CRR is considered an effective instrument for

monetary regulation and inflation control. The SLR is used to impose

financial discipline on the banks, provide protection to deposit-holders,

allocate bank credit between the government and the private sectors, and

also help in monetary regulation. However bankers strongly feel that

these along with high non-performing assets (on which banks do not earn

any return) 10 percent CRR and 25 percent SLR (most banks have SLR

investments way above the stipulation) are affecting banks' bottomlines.

With an effective return of a mere 2.8 per cent, CRR is a major drag on

banks' profitability.

The Narasimham Committee had argued for reductions in SLR on the

grounds that the stated government objective of reducing the fiscal

deficits will obviate the need for a large portion of the current SLR.

Similarly, the need for the use of CRR to control secondary expansion of

credit would be lesser in a regime of smaller fiscal deficits. The

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1.2 Reduction of SLR andCRR


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committee offered the route of Open Market Operations (OMO) to the

Reserve Bank of India for further monetary control beyond that provided

by the (lowered) SLR and CRR reserves. Ultimately, the rule was Reduction

in the reserve requirements of banks, with the Statutory Liquidity Ratio

(SLR) being brought down to 25 per cent by 1996-97 in a period of 5

years.

The recent trend in several developed countries (US, Switzerland,

Australia, Canada, and Germany) towards drastic lowering of reserve

requirements is often used to support the argument for reduced reserve

levels in India.

The arguments for higher or lower SLR and CRR ratios stem from two

different perspectives one which favours the banks, and the other which

favours the bank reserves as a monetary policy instrument. The bank

perspective seeks to maximise "lendable" resources, the banks' control

over resource deployment, and returns to the banks from the "preempted"funds. It is also claimed that the low returns from the forced investments

in government securities adversely affect the bank profitability - the cost

of deposits for banks, which averages at 15-16 per cent, was much

greater than the (earlier) returns on the government securities. This

argument is sometimes carried further to state that RBI makes profits on

impounded money, at the cost of bank profitability. To some extent, this

argument has been weakened by the increase in interest on government

securities to 13.5 per cent.

Some problems with the stated aim of reducing SLR and CRR are:

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1. The supporting condition of smaller fiscal deficits is not happening

in reality

2. Open market operations have not been used to any significant

extent in India for monetary control. The time required for gaining

experience with the use of such operations would be much more

than 5-6 years.

3. A commitment to a unidirectional movement of these vital controls

irrespective of the effects on, and the response of, other economic

factors (such as inflation), would be unwise.

This scenario thus indicates that despite the stated aim of reductions in

SLR and CRR, RBI may be forced to revert to higher reserve levels, if the

economic indicators become unfavourable, and RBI has already indicated

as much. Bank investment are, therefore, not likely to stabilize in the

near future.

The RBI had announced an increase in interest rate on CRR balance to 6%

from the present 4%. This will certainly boost the profits of banks, as they

have to maintain a minimum balance of 8% with the RBI.

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Trends in CRR and SLR 1993 2001

Illustration 1

16

0

5

10

15

20

25

30

35

40

May-

93

Nov-

93

May-

94

Nov-

94

May-

95

Nov-

95

May-

96

Nov-

96

May-

97

Nov-

97

May-

98

Nov-

98

May-

99

Nov-

99

May-

00

Nov-

00

May-

01

Percentageof

DTL

SLR CRR


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ChapterNo 03

Minimum

CapitalAdequacy

ratio

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The committee recommended a Stipulation of minimum capital adequacy

ratio of 4 per cent to risk weighted assets by March 1993, 8 per cent by

March 1996, and 8 per cent by those banks having international

operations by March 1994. Later, all banks required attaining the capital

adequacy norm of 8 per cent, as per the Basle Committee

Recommendations, by March 31, 1996.

Capital Adequacy

The growing concern of commercial banks regarding international

competitiveness and capital ratios led to the Basle Capital Accord 1988.

The accord sets down the agreement to apply common minimum capital

standards to their banking industries, to be achieved by year-end 1992.

Based on the Basle norms, the RBI also issued similar capital adequacy

norms for the Indian banks. According to these guidelines, the banks will

have to identify their Tier-I and Tier-II capital and assign risk weights to

the assets. Having done this they will have to assess the Capital to Risk

Weighted Assets Ratio (CRAR). The minimum CAR that the Indian banks

are required to meet is set at 9 percent.

Tier-I Capital, comprising of

Paid-up capitalStatutory Reserves

Disclosed free reserves

Capital reserves representing surplus arising out of sale

proceeds of assets

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1.3 Minimum Capital Adequacy


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Tier-II Capital, comprising of

Undisclosed Reserves and Cumulative Perpetual Preference Shares

Revaluation Reserves

General Provisions and Loss Reserves

The Narasimham Committee had recommended that the capital adequacy

norms set by the Bank of International Settlements (BIS) be followed by

the Indian banks also. The BIS norm for capital adequacy is 8 per cent of

risk-weighted assets.

Inadequacy?

The structural inadequacy that is said to be responsible for the stock scam

was the compartmentalisation of the capital and money markets; and the

availability of "illegal" arbitrage opportunities. Such interconnections

between various parts of the financial system will continue to develop as

the demands made by the rest of the economy on the financial system

increase in the next two decades. Also, a short-term danger of the new

provisioning and capital adequacy norms arises from the inefficiency of

the Asset Reconstruction Fund (ARF), or some alternative arrangement.

The need to make massive provisions obviously results in a depletion of

capital. But the capital adequacy norm means the banks have to find

additional, costly money to refurbish the capital base. In this situation,

the banks are being forced to accept the minimum possible amounts from

sub-standard and bad loans. Where time and legal efforts might have

forced them to pay more, errant loanees are now getting away with token

payments which the funds starved banks are only too willing to accept.

Thus, the need for ARF is now paramount.

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The banking sector specialists have traditionally claimed that capital plays

several roles in all "depository institutions", such as banks. However,

these roles can vary significantly between the public sector banks and

those in the private sector. The justification for capital adequacy norms

for banks is brought out by the following arguments:

Capital lowers the probability of bank failure more capital means

added ability to withstand unexpected losses, and more time for

the bank to work through potentially fatal problems. At the same

time, the Indian public sector banks may attract more"punishments" in the form of politically motivated "loan waivers",

"loan melas", and non-performing assets.

Capital increases the disincentive for the bank management to

take excessive risk: If significant amount of their own funds are at

stake, the equity-owners have a powerful incentive to control the

amount of risk the bank incurs. This may remain true for thepublic sector banks only if the government acts as a vigilant

shareholder. However, the government's ability to play such a

role effectively is suspect. The Indian banks have traditionally

shown risk-aversion, but the recent stock scam showed that the

banks are perhaps being forced to take excessive risks to improve

the profitability. Since management control will remain with

bureaucrats - banking or government - the source of capital would

not make much difference in the Indian scenario.

Capital acts as a buffer between the bank and the deposit

guarantee corporation (funded by the tax-payer): while this is true

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for the private banks, the government-owned capital in the public

sector banks is itself taxpayer money.

Capital helps avoid "credit crunches": a well-capitalized bank can

continue to lend in the face of losses. Similar losses might force a

poorly capitalized bank to restrict credit (to increase capital

ratios). In an economic downturn, well-capitalized banks may

provide a vital source of continuing credit.

Capital increases the long-term competitiveness: more capital

allows a bank to build long-term customer relationships, and

respond to positive as well as negative changes in the economicenvironment. New opportunities can be quickly made use of by

lending appropriately. If the bank is not constrained by capital, it

can give valuable time to customers with temporary repayment

problems. It can thereby recover more from the loans, which

would otherwise have to be called in.

The Dilemma

The foregoing discussion clearly brings out two conclusions: (a) increasing

the capital base of the nationalised banks is necessary, especially in view

of the large quantities of non-performing assets; and (b) however,

increase in capital owned directly by the government has several

attendant problems' The situation is complicated by the fact that " private

management" does not provide an answer in India, because of the size of

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the institutions involved. Also, talent and expertise in bank management

is available mainly in the existing nationalised banks.

One short-term fallout of the capital adequacy norms has been the

massive increases in investments by the banks in government securities.

Since the risk-weight of government securities is zero, investments in

them do not add to the capital requirements. The banks are therefore

choosing to deploy funds mobilised through deposits in these long-term

gilts.

In the first ten months of 1993-94, for example, the investments in

government securities shot up by 18.8 per cent while bank credit grew at

only 6.6 per cent. Despite a strong growth in aggregate deposits of 13.8

per cent, credit grew by only 6.65 per cent, while investments surged by

18.8 per cent. The problem with this practice of the banks is that it can

upset the balance of maturity patterns between deposits (many of ' which

are short-term) and investments (which have 10 year maturities). Now,

banks would have to develop much better investment management skills,

especially when interest rates are deregulated, and significant open

market operations are started.

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Growth In Investments In Government Securities by Banks

The Narasimham Committee II, 1998, suggested further revisioni.e. CAR to be raised to 10% from the present 8%(1998); 9% by

2000 and 10% by 2002

Illustration 2

24

1991-

92

1992-93 1992-93

[Up to Jan 93]

1993-94

[Up to Jan 94]

Aggregate deposits growth36441

[19.6 %]

32364

[14.0 %]

37187

[13.8 %]

Bank credit growth9291

[8.0 %]

26390

[21.0 %]

20966

[16.7 %]

9999

[6.6 %]

Investments 15131 1546011042

[12.2 %]

19857

[18.8 %]

Source: Reserve Bank of India Bulletin [1994]

Supplement - Report on Trends and Progress of Banking in India 1991-92 [July - June];

Jan 1993.


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ChapterNo 04

Prudential norms

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To get a true picture of the profitability and efficiency of the Indian Banks,

a code stating adoption of uniform accounting practices in regard to

income recognition, asset classification and provisioning against bad and

doubtful debts has been laid down by the Central Bank. Close to 16 per

cent of loans made by Indian banks were NPAs - very high compared to

say 5 per cent in banking systems in advanced countries.

Magnitude of the problem

According to the latest RBI figures, gross NPAs in the banking sector

stands at Rs 45,563 crore which is about 16 per cent of the total loan

assets of the banks. The net NPAs (gross NPAs minus provisioning) stands

at Rs 21,232 crore which is about 7 per cent of loans advanced by the

banking sector. Though in percentage terms, the NPAs have come down

over the last 5-6 years, in absolute terms they have grown, signifying that

while new NPAs are being added to banks' operations every year, recovery

of older dues is also taking too long.

What is ever greening or rescheduling of loans?

Sometimes, to avoid classifying problem assets as NPAs, banks give

another loan to the company with the help of which it can pay the due

interest on the original loan. While this allows the bank to project a

healthy image, it actually makes the problems worse, and creates more

NPAs in the long run. RBI discourages such practices.

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Asset Quality - Increased Transparency

Apart from the interest rate structure, the net interest income is also

affected by the asset quality of the bank. Asset quality is reflected by the

quantum of non-performing assets (NPAs) the higher the level of NPAs,

the lower will be the asset quality and vice versa. Courtesy the

nationalization agenda and the directed credit, most of the public sector

banks were burdened with huge NPAs. While the government did

contribute to write-off these bad loans, the problem still remains. NPAs

expose the banks to not just credit risk but also to liquidity risk.

Considering the implications of the NPAs and also for imparting greatertransparency and accountability in banks operations and restoring the

credibility of confidence in the Indian financial system, the RBI introduced

prudential norms and regulations. The prudential norms which relate to

income recognition, asset classification and provisioning for bad and

doubtful debts serve two primary purposes firstly, they bring out the

true position of a Banks loan portfolio, and secondly, they help

in arresting its deterioration.

The asset quality of the bank and its capital are closely associated. If the

assets of the bank go bad it is the capital that comes to its rescue. Implies

that the bank should have adequate capital to face the likely losses that

may arise from its risky assets. In the changed business environment,

where banks are exposed to greater and different types of risk, it becomesessential to have a good capital base, which can help it sustain

unforeseen losses. As stated earlier, the one major move in this direction

was brought about by the Basle Committee, which laid the capital

standards that banks have to maintain. This became imperative, as banks

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began to cross over their national boundaries and begin to operate in

international markets. Following the Basle Committee measures, RBI also

issued the Capital Adequacy Norms for the Indian banks also.

INCOME RECOGNITION

The regulation for income recognition states that the Income on NPAs

cannot be booked.

Interest income should not be recognized until it is realized. An NPA is

one where interest is overdue for two quarters or more. In respect

of NPAs, interest is not to be recognized on accrual basis, but is to be

treated as income only when actually received. Income in respect of

accounts coming under Health Code 5 to 8 should not be recognized until

it is realized. As regards to accounts classified in Health Code 4, RBI has

advised the banks to evolve a realistic system for income recognition

based on the prospect of realisability of the security. On non-performing

accounts the banks should not charge or take into account the interest.

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Income-recognition norms have been tightened for consortium banking

too. Member banks have to intimate the lead-bank to arrange for their

share of recovery. They will no more have the privilege of stating that the

borrower has parked funds with the lead-bank or with a member-bank and

that their share is due for receipt. The new notifications emanated after

deliberations held between the RBI and a cross-section of banks after a

working group headed by chartered accountant, PR Khanna, submitted its

report. The working group was set after the RBIs Board for Financial

Supervision (BFS) wanted divergences in NPA accounting norms by banksfrom central bank guidelines to be addressed. The working group had

identified three areas of divergence: non-compliance with RBI norms;

subjectivity arising out of the flexibility in norms; and differences in the

valuation of securities by banks, auditors and RBI.

As of now, for income recognition norms, the RBI has suggested that the

international norm of 90 days be implemented in a phased manner by

2002. The current norm is 180 days.

ASSET CLASSIFICATION

While new private banks are careful about their asset quality and

consequently have low non-performing assets (NPAs), public sector banks

have large NPAs due to wrong lending policies followed earlier and also

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due to government regulations that require them to lend to sectors where

potential of default is high. Allaying the fears that bulk of the Non-

Performing Assets (NPAs) was from priority sector, NPA from priority

sector constituted was lower at 46 per cent than that of the corporate

sector at 48 per cent.

Loans and advances account for around 40 per cent of the assets of SCBs.

However, delay/default in payment of interest and/or repayment of

principal has rendered a significant proportion of the loan assets non-

performing. As per RBIs prudential norms, a Non-Performing Asset (NPA)

is a credit facility in respect of which interest/installment has remained

unpaid for more than two quarters after it has become past due. Past

due denotes grace period of one month after it has become due for

payment by the borrower. The Mid-Term Review of Monetary and Credit

Policy for 2000-01 has proposed to discontinue this concept with effect

from March 31, 2001.

Regulations for asset classification

Assets should be classified into four classes - Standard, Sub-standard,

Doubtful, and Loss assets. NPAs are loans on which the dues are not

received for two quarters. NPAs consist of assets under three categories:

sub-standard, doubtful and loss. RBI for these classes of assets should

evolve clear, uniform, and consistent definitions. The health code system

earlier in use would have to be replaced. The banks should classify their

assets based on weaknesses and dependency on collateral securities into

four categories:

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Standard Assets: It carries not more than the normal risk attached to

the business and is not an NPA.

Sub-standard Asset: An asset which remains as NPA for a period

exceeding 24 months, where the current net worth of the borrower,

guarantor or the current market value of the security charged to the bank

is not enough to ensure recovery of the debt due to the bank in full.

Doubtful Assets: An NPA which continued to be so for a period

exceeding two years (18 months, with effect from March, 2001, as

recommended by Narasimham Committee II, 1998).

Loss Assets: An asset identified by the bank or internal/ external auditors

or RBI inspection as loss asset, but the amount has not yet been written

off wholly or partly.

The banking industry has significant market inefficiencies caused by the

large amounts of Non Performing Assets (NPAs) in bank portfolios,

accumulated over several years. Discussions on non-performing assets

have been going on for several years now. One of the earliest writings on

NPAs defined them as "assets which cannot be recycled or disposed off

immediately, and which do not yield returns to the bank, examples of

which are: Overdue and stagnant accounts, suit filed accounts, suspense

accounts and miscellaneous assets, cash and bank balances with other

banks, and amounts locked up in frauds".

The following Table shows the distribution of total loan assets of banks in

the public private sectors and foreign banks for 1997-98 through 1999-

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2000. It is worth noting that the ratio of incremental standard assets of

SCBs to their total loan assets increased from 83.1 per cent in 1998-99 to

97.2 percent in 1999-2000. In other words, the ratio of incremental NPAs

of SCBs to their total loan assets declined significantly from 16.9 per cent

in 1998-99 to 2.8 percent in 1999-2000.

Classification of Loan Assets of

SCBs

(Percentage distribution of total loan assets)

Assets Public Private Foreign SCBs

A. Standard

1997-98 84.0 91.3 93.6 85.6

1998-99 86.1 91.2 92.4 85.3

1999-2000 86.0 91.5 93.0 87.2

B. Sub-standard

1997-98 5.0 5.8 3.9 4.9

1998-99 4.9 6.2 4.0 5.0

1999-2000 4.3 3.7 2.9 5.1

C. Doubtful

1997-98 9.1 0.9 1.7 1.8

1998-99 4.0 0.9 2.0 1.9

1999-2000 1.7 0.8 1.9 1.6

D. Loss

1997-98 1.9 0.9 1.2 1.8

1998-99 2.0 0.9 2.0 1.9

1999-2000 1.7 0.8 1.9 1.6

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E. TotalAssets (Rs. Crore)

1997-98 284971 36753 30972 352696

1998-99 325328 43049 31059 399436

1999-2000 380077 58249 37432 475758

Note: Addition of percentages for B to D may not add up to 100 minus the

percentage share of standard assets (A) due to rounding.

The asset classification norms have resulted in a huge quantity of

assets being classified into the sub-standard, doubtful, and loss

assets. As at 31 March 1993, the total of Non-Performing Assets

(NPAs) for the public sector banks (SBI, its seven associates, and

20 nationalised banks) stood at Rs 36,588 crores. Of these, the

sub-standard assets account for Rs 12,552 crores, doubtful assets

Rs 20,106 crores, and loss assets Rs 3,930 crores (RBI Bulletin,1994). For the future, the banks will have to tighten their credit

evaluation process to prevent this scale of sub-standard and loss

assets. The present evaluation process in several banks is

burdened with a bureaucratic exercise, sometimes involving up to

18 different officials, most of whom do not add any value

(information or judgment) to the evaluation.

PROVISIONING NORMS

33

Note: Addition of percentages for B to D may not add up to 100 minusthe percentage share of standard assets (A) due to rounding.

( Illustration 3 )


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Banks will be required to make provisions for bad and doubtful

debts on a uniform and consistent basis so that the balance sheets

reflect a true picture of the financial status of the bank. The

Narasimham Committee has recommended the following

provisioning norms

(i) 100 per cent of loss assets or 100 per cent of out standings for

loss assets;

(ii) 100 per cent of security shortfall for doubtful assets and 20 per

cent to 50 per cent of the secured portion; and

(iii) 10 per cent of the total out standings for substandard assets.

A provision of 1% on standard assets is requiredas suggested by

Narasimham Committee II 1998. Banks need to have better credit

appraisal systems so as to prevent NPAs from occurring. The most

important relaxation is that the banks have been allowed to make

provisions for only 30 per cent of the "provisioning requirements"

as calculated using the Narasimham Committee recommendations

on provisioning (but with the diluted asset classification). The

nationalised banks have been asked to provide for the remaining

70 per cent of the"provisioning requirements" by 31 March 1994.The encouraging profits recently declared by several banks have to

be seen in the light of provisions made by them - Rs 10,390 crores

pertaining to 1992-93, and the additional provisions for 1993-94.

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To the extent that provisions have not been made, the profits

would be fictitious.

Chapter

No.0535


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Disclosure

norms

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Banks should disclose in balance sheets maturity pattern of

advances, deposits, investments and borrowings. Apart from this,

banks are also required to give details of their exposure to foreign

currency assets and liabilities and movement of bad loans. These

disclosures were to be made for the year ending March 2000

In fact, the banks must be forced to make public the nature of

NPAs being written off. This should be done to ensure that thetaxpayers money given to the banks as capital is not used to write

off private loans without adequate efforts and punishment of

defaulters.

# A Close look: For the future, the banks will have to tighten their credit

evaluation process to prevent this scale of sub-standard and loss assets.

The present evaluation process in several banks is burdened with a

bureaucratic exercise, sometimes involving up to 18 different officials,

most of whom do not add any value (information or judgment) to the

evaluation. But whether this government and its successors will continue

to play with bank funds remains to be seen. Perhaps even the loan

waivers and loan "melas" which are often decried by bankers form only a

small portion of the total NPAs. As mentioned above, much more

stringent disclosure norms are the only way to increase the

accountabil ity of bank management to the taxpayers. A lot

therefore depends upon the seriousness with which a new regime of

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1.5 Disclosure Norms


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regulation is pursued by RBI and the newly formed Board for Financial

Supervision.

RBI norms for consolidated PSU bank accounts

The Reserve Bank of India (RBI) has moved to get public sector banks to

consolidate their accounts with those of their subsidiaries and other outfits

where they hold substantial stakes.

Towards this end, RBI has set up a working group recently under its

Department of Banking Operations and Development to come out withnecessary guidelines on consolidated accounts for banks. The move is

aimed at providing the investor with a better insight into viewing a bank's

performance in totality, including all its branches and subsidiaries, and not

as isolated entities. According to a banker, earlier subsidiaries were

floated as external independent entities wherein the accounting details

were not incorporated in the parent bank's balance sheet, but at the same

time it was assumed that the problems will be dealt with by the parent.

This will be a path-breaking change to the existing norms wherein each

bank conducts its accounts without taking into consideration the

disclosures of its subsidiaries and other divisionsfor disclosure. As per the

proposed new policy guidelines, the banks will be required to consolidate

their accounts including all its subsidiaries and other holding companies

for better transparency.

# Result: This will require the banks to have a stricter monitoring system

of not only their own bank, but also the other subsidiaries in other sectors

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like mutual funds, merchant banking, housing finance and others. This is

all the more important in the context of the recent announcements made

by some major public sector banks where they have said they would hive

off or close down some of their under performing subsidiaries.

The Investors Advantage

Getting all these accounts consolidated with that of the parent bank will

provide the investor a better understanding of the banks' performances

while deciding on their exposures. More so, since a number of public

sector banks are now listed entities whose stocks are traded on the stock

exchanges. Some public sector banks are even preparing their accounts in

line with US GAAP norms in anticipation of a US listing. These norms will

therefore be in line with the future plans of these banks as well. The

working group was set up following the need to bring about transparency

on the lines of international norms through better disclosures.

These new norms will necessitate not only that the problems are handled

by the parent, but investors are also aware of what exactly the problems

are and how they affect the bottomlines of the parent banks. Now, under

the new guidelines, this will no longer be an external disclosure to the

parent banks' books of accounts.

Rather, point out bankers, this will very much form an integral part of the

parent's balance sheet.

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For instance, if a subsidiary is not performing well or making losses, this

will reflect in the parent's balance sheet.

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ChapterNo.06

Rationalization

Of foreignOperation in

indian

41

1.6 Rationalisation of Foreign Operations


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Liberalising the policy with regard to allowing foreign banks to open

offices in India or rather Deregulation of the entry norms for private sector

banks and foreign sector.

Entry of New Banks in the Private Sector

As per the guidelines for licensing of new banks in the private sector

issued in January 1993, RBI had granted licenses to 10 banks. Based on a

review of experience gained on the functioning of new private sector

banks, revised guidelines were issued in January 2001. The main

provisions/requirements are listed below : -

Initial minimum paid-up capital shall be Rs. 200 crore; this will be

raised to Rs. 300 crore within three years of commencement of

business.

Promoters contribution shall be a minimum of 40 per cent of the

paid-up capital of the bank at any point of time; their contribution of 40

per cent shall be locked in for 5 years from the date of licensing of the

bank and excess stake above 40 per cent shall be diluted after one year

of banks operations.

Initial capital other than promoters contribution could be raised

through public issue or private placement.

While augmenting capital to Rs. 300 crore within three years,

promoters need to bring in at least 40 percent of the fresh capital,

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which will also be locked in for 5 years. The remaining portion of fresh

capital could be raised through public issue or private placement.

NRI participation in the primary equity of the new bank shall be to

the maximum extent of 40 per cent. In the case of a foreign banking

company or finance company (including multilateral institutions) as a

technical collaborator or a co-promoter, equity participation shall be

limited to 20 per cent within the 40 per cent ceiling. Shortfall in NRI

contribution to foreign equity can be met through contribution by

designated multilateral institutions.

No large industrial house can promote a new bank. Individualcompanies connected with large industrial houses can, however,

contribute up to 10 per cent of the equity of a new bank, which will

maintain an arms length relationship with companies in the promoter

group and the individual company/ies investing in equity. No credit

facilities shall be extended to them.

NBFCs with good track record can become banks, subject to specified

criteria

A minimum capital adequacy ratio of 10 per cent shall be maintained

on a continuous basis from commencement of operations.

Priority sector lending target is 40 per cent of net bank credit, as in

the case of other domestic banks; it is also necessary to open 25 per

cent of the branches in rural/semi-urban areas.

"Our industry did not oppose the entry of private bankers because we

knew they will not be able to reach out to the rural markets states, G.M.

Bhakey, president of the State Bank of India Officers Association. "Even

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after privatisation not more than 10 per cent of the Indian population can

afford to open accounts in private banks."

Can the keenly supported private and foreign banks cater to the banking

needs of the people in India fairly? Takeover and merger dramas are in

progress in the world of private sector banks now and time only can tell

how many will live to render safe banking services in the days to come.

The bad debt figures even in the two to three year old new private sector

banks have crossed over 6% to the total advances, while the trends in the

old private banks are still higher, despite the fact that they have no social

commitment lendings in their portfolios.

In any case, the private banks, in the Indian context, cannot be the

alternative to our well-developed public sector banks. They are there in

the country to fill the private pockets with their typical selectivity of

business and costly operations. All those who beat their drums for the

privatisation parade, which is much on the move after globalisation, todenationalise our public sector banks, do so with vested interests.

ICICI bank, HDFC bank, GTB, IndusInd, BOP and UTI Bank have come out

with IPOs as per licensing requirement. Their technological edge and

product innovation has seen them gaining market share from the slower,

less efficient older banks. These banks have targeted non-fund based

income as major source of revenue, with their level of contingent liabilities

being much higher then their other counterparts viz. PSU and old private

sector banks. The new private banks have been consistently gaining

market shares from the public sector banks. The major beneficiary of this

has been corporate clients who are most sought after now.

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The new generation private sector banks have made a strong presence in

the most lucrative business areas in the country because of technology

upgradation. While, their operating expenses have been falling as

compared to the PSU banks, their efficiency ratios (employees

productivity and profitability ratios) have also improved significantly.

The new private sector banks have performed very well in the FY2000.

Most of these banks have registered an increase in net profits of over

50%. They have been able to make significant inroads in the retail market

of the public sector and the old private sector banks. During the year, the

two leading banks in this sector had set a new trend in the Indian banking

sector. HDFC Bank, as a part of its expansion plans had taken over Times

Bank. ICICI Bank became the first bank in the country to list its shares on

NYSE.

The Reserve Bank of India had advised the promoters of these banks to

bring their stake to 40% over a time period. As a result, most of thesebanks had a foreign capital infusion and some of the other banks have

already initiated talks about a strategic alliance with a foreign partner.

The main problems concerning the nationalized / state sector banks are as

follows:

A. Large number of unprofitable branches

B. Excess staffing of serious magnitude

C. Non Performing Assets on account of politically directed lending and

industrial recession in last few years

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D. Lack of computerization leading to low service delivery levels, non-

reconciliation of accounts, inability to control, misuse and fraud etc

E. Inability to introduce profitable new consumer oriented products like

credit cards, ATMs etc

The private edge

Technology- The private banks have used technology to provide

quality service through lower cost delivery mechanisms. The

implementation of new technology has been going on at very rapid

pace in the private sector, while PSU banks are lagging behind in therace.

Declining interest rates- in the present scenario of declining

interest rates, some of the new private banks are better able to

manage the maturity mix. PSU Banks by and large take relatively long-

term deposits at fixed rates to lend for working capital purposes at

variable rates. It therefore is negatively affected when interest rates

decline as it takes time to reduce interest rates on deposits when

lending has to be done at lower interest rates due to competitive

pressures.

NPAs- The new banks are growing faster, are more profitable and

have cleaner loans. Reforms among public sector banks are slow, as

politicians are reluctant to surrender their grip over the deployment of

huge amounts of public money.

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Convergence-The new private banks are able to provide a range

of financial services under one roof, thus increasing their fee based

revenues.

List of Banks operating in India.

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ChapterNo 07

Special tribunals

And assetreconstruction

fund

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Setting up of special tribunals to speed up the process of recovery of loans

and setting up of Asset Reconstruction Funds (ARFs) to take over from

banks a portion of their bad and doubtful advances at a discount was one

of the crucial recommendations of the Narasimham Committee.

To expedite adjudication and recovery of debts due to banks and financial

institutions (FIs) at the instance of the Tiwari Committee (1984), appointed

by the Reserve Bank of India (RBI), the government enacted the Debt

Recovery Tribunal Act, 1993 (DRT). Accordingly, DRTs and Appellate DRTs

have been established at different places in the country. The act was

amended in January 2000 to tackle some problems with the old act.

DRTs, a compulsion!

One of the main factors responsible for mounting non-performing assets

(NPAs) in the financial sector has been the inability of banks/FIs to enforce

the security held by them on loans gone sour. Prior to the passage of the

DRT Act, the only recourse available to banks/FIs to cover their dues from

recalcitrant borrowers, when all else failed, was to file a suit in a civil

court. The result was that by the late 80s, banks had a huge portfolio of

accounts where cases were pending in civil courts. It was quite common

for cases to drag on interminably. In the interim, borrowers, more often

than not, stripped their premises of all assets so that that by the time the

final verdict came, there was nothing left of the security that had been

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pledge to the bank

The Advantage

DRTs, it was felt, would do away with the costly, time-consuming civil

court procedures that stymied recovery procedures since they follow a

summary procedure that expedites disposal of suits filed by banks/FIs.

Following the passage of the Act in August 1993, DRTs were set up at

Calcutta, Delhi, Bangalore, Jaipur and Ahmedabad along with an Appellate

Tribunal at Mumbai.

However, DRTs soon ran into rough weather. The constitutional validity of

the Act itself was questioned. It was only in March 1996, that the Supreme

court modified its earlier order staying the operation of the Delhi High

Court order quashing the constitution of the DRT for Delhi to allow the

setting up of three more DRTs in Chennai, Guwahati and Patna.

Subsequently, many more DRTs and ADRTs have been set up.

The truth undiscovered, CURRENT STATUS AND

BANKERS COMPLAINS !

Unfortunately, as a consequence of the numerous lacunae in the act and

the huge backlog of past cases where suits had been filed, DRTs failed to

make a significant dent. For instance, the tribunals did not have powers of

attachment before judgment, for appointment of receivers or for ordering

preservation of property

Thus, legal infrastructure for the recovery of non-performing loans still

does not exist. The functioning of debt recovery tribunals has been

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hampered considerably by litigation in various high courts. Complains

Bank of Baroda's Kannan: "Of the Rs 45,000-crore worth of gross NPAs,

over Rs 12,000 crore is locked up in the courts." So, the only solution to

the problem of high NPAs is ruthless provisioning. Till date, the banking

system has provided for about Rs 20,000 crore, which means it is still

stuck with net NPAs worth Rs 25,000 crore. Even that is an under estimate

as it does not include advances covered by government guarantees,

which have turned sticky. Nor does it include allowances for "ever

greening"--the practice of extending fresh advances to defaulting

corporates so that the prospective defaulter can make interest payments,thus enabling the asset to escape the non-performing loan tag. Warns K.R.

Maheshwari, 60, Managing Director, IndusInd Bank: "NPA levels are going

to go up for all the banks." And so too will provisions.

Recent Developments

The recent amendment (Jan 2000) to the DRT Act addresses many of the

lacunae in the original act. It empowers DRTs to attach the property on

the borrower filing a complaint of default. It also empowers the presiding

officer to execute the decree of the official receiver based on the

certificate issued by the DRT. Transfer of cases from one DRT to another

has also been made easier. More recently, the Supreme Court has ruled

that the DRT Act will take precedence over the Companies Act in therecovery of debt, putting to rest all doubts on that score.

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SOME MORE ISSUES

As things stand, the DRT Act supersedes all acts other than The Sick

Industrial Companies Act (SICA). This means that recovery procedures can

still be stalled by companies declaring themselves sick under SICA. Once

the fact of their sickness has prima facie been accepted by the Board for

Industrial and Financial Reconstruction (BIFR), there is nothing a DRT can

do till such time as the case is disposed of by the BIFR. This lacuna too

must be addressed if DRTs are to live up to their promise.

The amendments would ensure speedy recovery of dues, iron out delays

at the DRT end, as well as ensure that promoters do not have the time

and opportunity to bleed their companies before they go into winding up.

Yet the number of cases pending before DRTs and courts make a tellingcommentary on the inability of lenders to make good their threat. They

also reflect the ability of borrowers to dodge the lenders.

The main culprit for all this is the law. Existing recovery processes in the

country are aimed at recovering lenders' dues after a company has gone

sick and not nipping sickness in the bud. Since sickness is defined in law

as the erosion of capital of a company for three consecutive years, there

is little to recover from a sick company after it has been referred to the

Board of Industrial and Financial Revival (BIFR).

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What's hurting banks now is the fact that these new issues have cropped

up even as they have been (unsuccessfully) wrestling with their NPAs

which, together, tot up to a staggering Rs 60,000 crore. The stratagem of

using Debt Recovery Tribunals has failed. Now these banks have to

explore the option of liquidating the assets of defaulting companies (a

litigitinous route), or writing off these debts altogether (which may not find

favour with shareholders). The solution could lie in better risk

management

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ChpterNo 08

Restructuring

Of weak banks

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How to deal with the weak Public Sector Banks is a major problem for the

next stage of banking sector reforms. It is particularly difficult because the

poor financial position of many of these banks is often blamed on the fact

that the regulatory regime in earlier years did not place sufficient

emphasis on sound banking, and the weak Banks are, therefore, not

responsible for their current predicament. This perception often leads to

an expectation that all weak Banks must be helped to restructure after

which they would be able to survive in the new environment.Keeping in view the urgent need to revive the weak banks, the Reserve

Bank of India set up a Working Group in February, 1999 under the

Chairmanship of Shri M.S. Verma to suggest measures for the revival of

weak public sector banks in India.

The major recommendations/points of the Working Group, which

56

THE VERMA PRESCRIPTIONa brief

Identification of weak banks by using benchmarks for 7

critical ratios Recapitalisation of 3 weak banks conditional on their

achieving specified milestones

Five-year freeze on all wage-increases, including the 12.25%increase negotiated by the IBA

A 25% reduction in staff-strength, either through VRSs orthrough wage-cuts

Branch rationalisation, including the closure of loss-makingforeign branches

Transfer of non-performing assets to an Asset Reconstruction

Fund

Reconstitution of bank boards to include professionals,industrialists and financial experts

Independent Financial Restructuring Authority to monitorimplementation of revival package

1.8 Restructuring of WeakBanks


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Seven parameters covering three areas have been identified;

these are (i) Solvency (capital adequacy ratio and coverage ratio),(ii) Earning Capacity (return on assets and net interest margin)

and (iii) Profitability (ratio of operating profit to average working

funds, ratio of cost to income and ratio of staff cost to net interest

+ income all other income).

Restructuring of weak banks should be a two-stage operation;

stage one involves operational, organisational and financial

restructuring aimed at restoring competitive efficiency; stage two

covers options of privatisation and/or merger.

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Operational restructuring essentially involves building up

capabilities to launch new products, attract new customers,

improve credit culture, secure higher fee-based earnings, sell

foreign branches (Indian Bank and UCO Bank) to prospective

buyers including other public sector banks, and pull out from the

subsidiaries (Indian Bank), establish a common networking and

processing facility in the field of technology, etc.

The action programme for handling of NPAs should cover

honouring of Government guarantees, better use of compromisesfor reduction of NPAs based on recommendations of the

Settlement Advisory Committees, transfer of NPAs to ARF

managed by an independent AMC,etc.

To begin with, ARF may restrict itself to the NPAs of the three

identified weak banks; the fund needed for ARF is to be providedby the Government; ARF should focus on relatively larger NPAs

(Rs. 50 lakh and above).

A 30-35 percent reduction in staff cost required in the three

identified weak banks to enable them to reach the median level of

ratio of staff cost to operating income.

In order to control staff cost, the three identified weak banks

should adopt a VRS covering at least 25 percent of the staff

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strength; for the three banks taken together, the estimated cost of

VRS ranges from Rs. 1100 to Rs. 1200 crore.

The organisational restructuring includes delayering of the

decision making process relating to credit, rationalisation of

branch network, etc.

Experts have also suggested the concept of narrow banking,

where only strong and efficient banks will be allowed to give

commercial loans, while the weak banks will take positions in lessrisky assets such as government securities and inter-bank lending.

The three identified banks on committee recommendations were UCO

bank, United Bank of India and Indian Bank.

In August 2001, the government of India directed UCO Bank to shut down800 branches and also 4 international operations in line with the Verma

committee recommendation on sick banks. Three more PSBs declared sick

are Dena Bank, Allahabad Bank and Punjab and Sindh Bank. UCO bank

had been posting losses for the past eleven years.

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ChapterNo.09

Asset liability

ManagementSystem

60

1.9 Asset Liability Management


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The critical role of managing risks has now come into the open, especially

against the experience of the recent East Asian crisis, where markets fell

precipitously because banks and corporates did not accurately measure

the risk spread that should have been reflected in their lending activities.

Nor did they manage such risks or provide for them in their balance

sheets. In India, the Reserve Bank has recently issued comprehensive

guidelines to banks for putting in place an asset-liability management

system. The emergence of this concept can be traced to the mid 1970s in

the US when deregulation of the interest rates compelled the banks to

undertake active planning for the structure of the balance sheet. Theuncertainty of interest rate movements gave rise to interest rate risk

thereby causing banks to look for processes to manage their risk. In the

wake of interest rate risk came liquidity risk and credit risk as inherent

components of risk for banks.The recognition of these risks brought Asset

Liability Management to the centre-stage of financial intermediation.

The necessity

The asset-liability management in the Indian banks is still in its nascent

stage. With the freedom obtained through reform process, the Indian

banks have reached greater horizons by exploring new avenues. The

government ownership of most banks resulted in a carefree attitude

towards risk management. This complacent behavior of banks forced the

Reserve Bank to use regulatory tactics to ensure the implementation of

the ALM. Also, the post-reform banking scenario is marked by interest rate

deregulation, entry of new private banks, gamut of new products and

greater use of information technology. To cope with these pressures banks

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were required to evolve strategies rather than ad hoc fire fighting

solutions. Imprudent liquidity management can put banks' earnings and

reputation at great risk. These pressures call for structured and

comprehensive measures and not just ad hoc action. The Management of

banks has to base their business decisions on a dynamic and integrated

risk management system and process, driven by corporate strategy.

Banks are exposed to several major risks in the course of their business -

credit risk, interest rate risk, foreign exchange risk, equity / commodity

price risk, liquidity risk and operational risk. It is, therefore, important that

banks introduce effective risk management systems that address theissues related to interest rate, currency and liquidity risks.

Implementation of asset liability management (ALM) system

RBI has issued guidelines regarding ALM by which the banks have to

ensure coverage of at least 60% of their assets and liabilities by Apr 99.

This will provide information on banks position as to whether the bank is

long or short. The banks are expected to cover fully their assets and

liabilities by April 2000.

ALM framework rests on three pillars

ALM Organisation:

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The ALCO consisting of the banks senior management including CEO

should be responsible for adhering to the limits set by the board as well as

for deciding the business strategy of the bank in line with the banks

budget and decided risk management objectives. ALCO is a decision-

making unit responsible for balance sheet planning from a risk return

perspective including strategic management of interest and liquidity risk.

Consider the procedure for sanctioning a loan. The borrower who

approaches the bank, is appraised by the credit department on various

parameters like industry prospects, operational efficiency, financial

efficiency, management evaluation and others which influence theworking of the client company. On the basis of this appraisal the borrower

is charged certain rate of interest to cover the credit risk. For example, a

client with credit appraisal AAA will be charged PLR. While somebody with

BBB rating will be charged PLR + 2.5 %, say. Naturally, there will be

certain cut-off for credit appraisal, below which the bank will not lend e.g.

Bank will not like to lend to D rated client even at a higher rate of interest.

The guidelines for the loan sanctioning procedure are decided in the ALCO

meetings with targets set and goals established

ALM Information System

ALM Information System for the collection of information accurately,

adequately and expeditiously. Information is the key to the ALM process. A

good information system gives the bank management a complete picture

of the bank's balance sheet.

ALM Process

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The basic ALM process involves identification, measurement and

management of risk parameters. The RBI in its guidelines has asked Indian

banks to use traditional techniques like Gap Analysis for monitoring

interest rate and liquidity risk. However RBI is expecting Indian banks to

move towards sophisticated techniques like Duration, Simulation, VaR in

the future.

Is it possible ?

Keeping in view the level of computerisation and the current MIS in banks,

adoption of a uniform ALM Systemfor all banks may not be feasible. Thefinalguidelines have been formulated to serve as a benchmark for those

banks which lack a formal ALM System. Banks that have already adopted

more sophisticated systems may continue their existing systems but they

should ensure to fine-tune their current information and reporting system

so as to be in line with the ALM System suggested in the Guidelines. Other

banks should examine their existing MIS and arrange to have an

information system to meet the prescriptions of the new ALM System. In

the normal course, banks are exposed to credit and market risks in view of

the asset-liability transformation. Banks need to address these risks in a

structured manner by upgrading their risk management and adopting

more comprehensive Asset-Liability Management (ALM) practices than has

been done hitherto

But, ultimately risk management is a culture that has to develop

from within the internal management systems of the banks. Its

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critical importance will come into sharp focus once current restrictions on

banks portfolios are further liberalised and are subjected to the pressure

of macro economic fluctuations.

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Chapter no 10Reduction of

Government stake in

psbs

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This is what the finance minister said in his budget speech on February

29, 2000;

"In recent years, RBI has been prescribing prudential norms for

banks broadly consistent with international practice. To meet the

minimum capital adequacy norms set by the RBI and to enable

the banks to expand their operations, public-sector banks will

need more capital. With the Government budget under severe

strain, such capital has to be raised from the public which will

result in reduction in government shareholding. To facilitate this

process, the Government has decided to accept the

recommendations of the Narasimham Committee on Banking

Sector Reforms for reducing the requirement of minimum

shareholding by government in nationalised banks to 33 per

cent. This will be done without changing the public-sector

character of banks and while ensuring that fresh issue of shares

is widely held by the public."

Banking is a business and not an extension of government. Banks must be

self-reliant, lean and competitive. The best way to achieve this is to

privatise the banks and make the managements accountable to real

shareholders. If "privatisation" is a still a dirty word, a good starting point

for us is to restrict government stake to 33 per cent.

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During the winter session of the Parliament, on 16 November 2000, the

Union Cabinet has taken certain decisions, which have far reaching

consequences for the future of the Indian banking sector cleared

amendment of the Banking Companies (Acquisitions and Transfer of

Undertakings) Act 1970/1980 for facilitating the dilution of governments

equity to 33 percent

Governments action programmehas expressed clearly its programme for

the dilution of its stake in bank equity. The Cabinet had taken this

decision, immediately on the next day after the bank employees went on

strike, is a clear indication of Government of Indias determination toamend the concerned Acts, to pave the way for the reduction in its stake.

The proposal had been to reduce the minimum shareholding from 51 per

cent to 33 per cent, with adequate safeguards for ensuring its control on

the operations of the banks. However, it is not willing to give away the

management control in the nationalised banks. As a result public sector

banks may find it very difficult to attract strategic investors.

SALIENT FEATURES of the proposed amendments

Government would retain its control over the banks by stipulating

that the voting rights of any investor would be restricted to one

per cent, irrespective of the equity holdings. The government would continue to have the prerogative of the

appointment of the chief executives and the directors of the

nationalised banks. There has been considerable delay in the past in

filling up the posts of the chairman and executive director of some banks.

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It is not clear as to how this aspect would be taken care of in future. It is

said that the proposed amendment to the Act would also give the board of

banks greater autonomy and flexibility.

It has been decided to discontinue the mandatory practice of

nominating the representatives of the government of India and

the Reserve Bank in the boards of nationalised banks. This decision

is in tune with the recommendation of Narasimham committee. However,

the government would retain the right to nominate its representative in

the boards and strangely a nominee of the government can be in

more than one bankafter the amendment. The number ofwhole time directors would be raised to four

as against the present position of two, the chairman and

managing director and the executive director. While conceptually it

is desirable to decentralise power, operationally it may be difficult to

share power at peer level. In quite a few cases, it was observed that inter

personal relations were not cordial among the two at the top. It has to be

seen as to how the four full time directors would function in unison.

It is proposed to amend the provisions in the Banking Companies

(Acquisition and Transfer of Undertakings) Act to enable the bank

shareholders to discuss, adopt and approve the annual accounts

and adopt the same at the annual general meetings.

Paid-up capital of nationalised banks can now fall below 25 per

cent of the authorised capital.

Amendment will also enable the setting up of bank-specific

Financial Restructuring Authority (FRA). Authority will be empowered to

take over the management of the weak banks. Members of FRA will

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comprise of experts from various fields & will be appointed by the

government, on the advice of Reserve Bank of India.

The government has been maintaining that the nationalised

banks would continue to retain public sector character even after

the reduction in equity.

This is the reason why the banks would continue to be statutory bodies

even after the reduction in government equity below 51 per cent and the

banks would not become companies. This implies that they would

continue to be subject to parliamentary and other scrutiny despiteproposed relaxations.

The measures seen in totality are clearly aimed at enabling banks to

access the capital markets and raise funds for their operations. The

Government seems to have no plans to reduce its control over these

banks. The Act will also permit it to transfer its stake if the need arises,

apart from granting banks the freedom to restructure their equity.

Reserve Banks perception; the Reserve Bank has been emphatic in its

views on lowering the stake of the government in the equity of

nationalized banks:

The panel wants government stake to be diluted to less than 50 per

cent in order to make banks' decision-making more autonomous. It

has said, in view of the severe budgetary strain of the government, the

capital has to be raised from the public, which leads to a reduction in

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government shareholding. The process of the transition from public

sector to the joint sector has already been initiated with 7 of the public

sector banks accessing the capital market for expanding their capital

base. Since total privatization is not contemplated, the banks in the joint

sector are expected to control the commanding heights of the banking

business in the years to come.

In the domestic context, the idea behind a reduction in government

stake is to free bank employees from being treated as "public

servants." Instead, by directly reducing the government stake below 50per cent, the banks will be free from the shackles of the central vigilance

commission.

Official sources explained that this has been done to enable banks to

clean up their balance sheets so that they can access the capital

market easily. In terms of transferring equity, the government is

arming itself with powers to sell its stake if it so desires at a later

date.

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A LOOK AT PAST

The Indira Gandhi government had nationalised 14 commercial banks

through the Banking Companies (Acquisitions and Transfer of

Undertakings) Ordinance in 1969. The 1970 and 1980 Acts brought about

after the nationalisation of 14 and 6 banks respectively were first

amended in 1994 to allow government to reduce its equity in them to up

to 49 per cent. The 20 nationalised banks became 19 subsequently after

New Bank of India merged with Punjab National Bank. Only six of these 19

banks have so far accessed the market and to gone for public issues meet

its additional capital needs. The government holds majority or entire

equity of 19 nationalised banks currently.

Till now, banks could reduce equity only up to 25 per cent of the paid up

capital on the date of nationalisation. Some banks like the Bank of Baroda

have returned equity to the government in the past, but that has been

within the prescribed 25 per cent cap.

The Nationalisation Act provides that the PSU banks cannot sell a single

share. This is the reason why banks have been tapping the market to fund

their expansion plans. Also the Act originally provided that the

government must mandatorily hold 100 per cent stake in banks. The 1994

amendments brought it down to 51 per cent, to help induction of public as

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shareholders.

At this stage, the government provided that all shares, excluding

government shares could be transferred. This was necessary to permit the

transfer of shares when public shareholders sold their stake in banks. The

amendments remove restrictions on the transfer of government

shareholding.

What did they have to say ?

Union parliamentary affairs minister Pramod Mahajan said:

The amendment is an enabling provision. We are only making iteasier for banks to access funds from the market...It is not the

intention of the government to privatise these banks or enter into

strategic alliances with private sector.

Why should the taxpayers money be used repeatedly for

improving the capital base of the public sector banks?

19075032 indian banking sector reforms

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