banking sector reform (2)

7/31/2019 Banking Sector Reform (2)

1/29

BANKING SECTORREFORMS


2/29

Major Reform Initiatives:

When was it initiated? Banking sector reforms is a part andparcel of the financial sector reforms, and was initiated in 1991.

Why was it necessary? Was necessary so as to remove the

deficiencies in the financial sector, particularly in the bankingsector to strengthen the economic reforms.

What was the Object? The objectives of reforms were to

strengthen the Indian banks, make them internationallycompetitive and encourage them to play an effective role in theacceleration of the process of growth. Also, measures were to be adopted for improving the

productivity, efficiency and profitability of the bankingsystem.

To place the Indian Banking system at par with internationalstandards in respect of capital adequacy and other prudentialnorms.

The operational rigidities in credit delivery system were to beremoved to ensure allocation efficiency and achievement ofsocial objectives.

The policy initiatives taken in this regard were largely based on

the recommendations of Narasimham Committee I & II onfinancial sector and Banking sector reforms


3/29

Major Highlights of Narasimham

Committee I Report Phased reductions of Statutory Pre-emptions (SLR to 25%

CRR to 10%) Interest Rate on CRR Balances (Cash balance above the

basic minimum of 3%) Phasing Out Directed Credit

Programme (Constituents of the priority sector should beredefined)

Interest Rate Deregulation (Gradual move towards marketdetermined interest rates)

Income Recognition: (Assets should be recognised at theirrealisable value. Uniform accounting policy should beadopted. NPA recognition)


4/29

Asset Classification: (Standard, Sub Standard, doubtfuland loss asset)

Transparency: Tax Treatment of Provisions:

Loan Recovery: (tribunals)

Tackling Doubtful Debts:(A special asset reconstructionfund co. should be set up)

Restructuring the Bank: (Consolidations)

Entry of Private Banks: encourage pvt. sectorparticipation

Branch Licensing: (it should be abolished)

Foreign Banks Supervision of Banks: over-regulated banking env.

Control of Banking System: Only RBI & not RBI & Ministryof Fin.


5/29

Major Highlights of Narasimham

Committee II Report Merger in Strong public sector banks & not merger of

strong and weak.

Should have greater autonomy with respect to

recruitment and other personnel related matters andgeneral management

Restructuring and Recapitalisation of weak public sectorbanks

Rather than focusing only on asset management banksshould emphasize on asset-liability mgt. instead.

Better understanding of the financial market in terms ofinterdependence of various market segments.

Greater specialisation of banks in niche areas as retail,

agriculture, ssi, corporate financing etc.


6/29

Banks should place greater reliance on non fundbusiness such as advisory and consultancy services.

Banks should concentrate on management of credit riskand better mgt. of NPA advances.

To improve the financial health of the banks the capitaladequacy ratio be raised to 9% by march 2000 and 10%

by 2002. Assets should be classified as doubtful if it is in the

substandard category for 18 months in the first instanceand eventually 12 months and LOST if it had been soidentified but not written off.

Also Govt. guaranteed advances which has turned stickyshould be classified as NPAs.

The committee recommended that a gen prov. of 1%should be introduced on standard assets and avoid the

practice of evergreening.


7/29

The Committee recommended that the Govt. shouldguarantee issue of bonds for tier II capital by banks.These instruments would be eligible for SLR investments.

Banks should continue with their present practice ofpriority sector lending. Branch managers should be madefully responsible for identification of beneficiaries, interest

subsidy and so on. Functions of Board and Management should be reviewed

and also recommended strongly for professionalisationand depoliticisation of bank boards, specially in respect ofnon official directors.


8/29

Banking Sector Reforms: Phase I (NarsimhamCommittee I Recommendation)

Deregulation of Interest Rate Structure Progressive reduction of Pre-emptive reserves

Liberalisation of the branch expansion policy

Introduction of prudential norms to ensure capital adequacy, properincome recognition classification of assets based on their quality andprovisioning against bad and dd.

Decreasing the emphasis laid on directed credit and phasing out theconcessional rate of interest to priority sectors

Deregulation of the entry norms for Pvt. Sector an Foreign banks

Permitting private and public sector banks to access the capital market Setting up of the asset reconstruction fund

Constituting the special debt recovery tribunal

Freedom to appoint chief executive and officers of the bank

Changes in constitution of the board

Bringing NBFCs under the ambit of regulatory framework

Summary


9/29

Capital Adequacy: CAR be raised from 8 to 10% by 2002

100 % Fxd Income portfolio mark to market by 2001

5% mkt risk weight for Fixed income securities

Commercial Risk weight (100%) to Govt guaranteed advances

Asset Quality: Banks should aim to reduce gross NPA to 3% and net NPA to 0% by 2002

90 day overdue norm to be applied for cash based income recognition

Govt. guaranteed irregular accounts to be classified as NPAs

Asset reconstruction COs to take over NPAs

Directed credit obligation to be reduced from 40 to 10% Mandatory general provisions of 1% of standard assets and specific

provisions to be made tax deductible.

System and Methods: Banks to start recruitment of skilled, specialised manpower from the

market

Banking Sector Reforms: Phase II (NarsimhamCommittee II Recommendation)

Summary


10/29

Overstaffing to be dealt with redeployment and right sizing

PSBs to be given flexibility in remuneration structure

Rapid introduction of computerisation and technology

Industry Structure: Only 2 categories 1) banks and 2) NBFCs

Merges to be driven by market and business consideration

Weak banks to convert to narrow banks, restructure or close down

Entry of New Pvt Sector Banks and Foreign Banks to continue

Banks to be given greater financial autonomy, and min Govt. shareholdings to bereduced to 33% fro 55% for SBI and to 51% for other PSBs

Regulation Supervision Banking regulation and supervision to be progressively delinked from monetary policy

Board for Financial Reconstruction and Supervision to be constituted with statutorypowers

Greater emphasis on public disclosure than disclosures to regulators

Legal Amendments: Broad range of legal reforms to facilitate recovery problems

Introduction of laws governing electronic funds transfer

Amendments in the BRAct , Nationalisation Act and SBI Act to allow greater

autonomy


11/29

MAJOR REFORM

INITIATIVES


12/29

Banks now enjoy greater operational freedom in terms ofconducting their business and employing measures toconfront market forces. But, such freedom is of course,limited within the frontiers of prudential norms andprescribed RBI guidelines. Control, regulation andsupervision of the banking system has been liberalized toa considerable extent in the following directions:

Sharp reduction in pre-emption: (SLR 25% & CRR 5%)Controls on credit & Interest rate deregulation (there hasbeen a considerable disbanding of administered interestrates except a part on priority sector adv.)Improvement in payment and settlement mechanism:Enhancement in Short-term liquidity Management: (Introduction of pure inter-bank call money market andauction-based repos-reserve for short-term liquidityManagement )Pricing of Government Securities: (Market determinedpricing system)

1. Greater Operational Freedom due toDeregulatory Measures:


13/29

The PSBs (Public sector banks) can henceforth acquireany company like a private sector, NBFC or other business to increase their balance sheet

size. They can also exit non-profitable areas. For any such move, they will not have to take specific

clearances from the government.

Also the public sector banks will be permitted to pursuenew lines of businesses as a part of overall businessstrategy.

Banks are now allowed to issue preference shares since itis treated as regulatory capital under Basel norm.

Public sector banks can now raise capital from equity

market up to 49% of their paid-up capital. Banks with a good track record of profitability have

greater flexibility in recruitment and branchrationalization.

2. Greater Managerial Autonomy:


14/29

Banks could now diversify their:

Business Activities: Like leasing, insurance,

infrastructure financing, factoring, gold banking,investment banking, asset management, creditcards etc.

Product portfolio: New instruments have beenintroduced for greater flexibility and better risk

management: e.g. interest rate swaps, forward rateagreements, liquidity adjustment facility for meetingday-to-day liquidity mismatch

With banks permitted to diversify into long-term finance andDFIs into working capital, guidelines have been put in place

for the evolution of universal banking in an orderly fashion.


15/29

3. Competition Enhancing Measures: New private sectorbanks have been set up and foreign banks permitted toexpand their operations in India directly or through

subsidiaries.

Overseas investment Limits: 1) Limits for investment inoverseas markets by banks, mutual funds and corporateshave been liberalised. 2) Banks have also been allowed toset up Offshore Banking Units in Special EconomicZones. 3) The overseas investment limit for corporates

has been raised to 100% of net worth and the ceiling of$100 million on prepayment of external commercialborrowings has been removed. 4) MFs and corporates cannow undertake FRAs with banks. 5) Indians are nowallowed to maintain resident foreign currency (domestic)accounts. 6) Full convertibility for deposit schemes of

NRIs has been introduced. FDI investment in Private Banks: The limit for foreign

direct investment in private banks has been increasedfrom 49% to 74% and the 10% cap on voting rights hasbeen removed. In addition, the limit for foreigninstitutional investment in private banks is put at 49%.


16/29

Reduction of Government equity in banks: Governmentholdings are reducing and strong banks have beenallowed to access the capital market for raising

additional capital. Consolidation as a strategy to meet Global Competition:

(At present only one Indian bank figures in S&Ps list of300 top banks viz; SBI which ranks 82nd.


17/29

4.Institutional and Legal Initiatives

The Recovery of Debts due to Banks and FinancialInstitutions Act, (DRT Act) 1993- Under the DRT act DebtRecovery Tribunals were set up for recovery of loans ofbanks and financial institution. These tribunals havereduced the recovery period to about a year as against 5to7 year in the civil court.

SARFAESI (Securitization and reconstruction of financialassets and enforcement of security interest) Act, 2002.This has largely been possible due to SARFAESI Act,2002. This act has empowered banks with regard torecovery of defaulted loan.

Setting up of new institutions: Several new institutionshave been set up including the National SecuritiesDepositories Ltd., Central Depositories Services Ltd.,Credit Information Bureau India Ltd. (for informationsharing on defaulters as also other borrowers.), ClearingCorporation of India Ltd (CCIL) which acts as centralcounter party for facilitating payments and settlementsystem relating to fixed income securities and moneymarket instruments.


18/29

Move towards Basel II Accord: The New Basel Capital Accord, often

referred to as the Basel II Accord or simply Basel II, was approved by theBasel Committee on Banking Supervision of Bank for InternationalSettlements in June 2004 and suggests that banks and supervisorsimplement it by beginning 2007, providing a transition time of 30 months.It is estimated that the Accord would be implemented in over 100countries, including India.

Basel II takes a three-pillar approach to regulatory capital measurement

and capital standards - Pillar 1 (minimum capital requirements); Pillar 2(supervisory oversight); and Pillar 3 (market discipline and disclosures).

Pillar 1 spells out the capital requirement of a bank in relation to thecredit risk in its portfolio, which is a significant change from the one sizefits all approach of Basel I, and specifies new standards for minimum capitalrequirements, along with the methodology for assigning risk weights on thebasis of credit risk and market risk and Also specifies capital requirement foroperational risk.

Pillar 2 Enlarges the role of banking supervisors and gives them power toreview the banks risk management systems.

Pillar 3 Defines the standards and requirements for higher disclosure bybanks on capital adequacy, asset quality and other risk management

processes.

4.Institutional and Legal Initiatives


19/29

Approach of the Reserve Bank of India to Basel II Accord: TheReserve Bank of India (RBI) had asked banks to move in thedirection of implementing the Basel II norms. The aim was to reachthe global best standards in a phased manner, taking a consultativeapproach rather than a directive one. In anticipation of Basel II, RBIhad requested banks to examine the choices available to them anddraw a roadmap for migrating to Basel II.

The RBI had set up a steering committee to suggest migrationmethodology to Basel II. Based on recommendations of the Steering

Committee, in February 2005, RBI had proposed the DraftGuidelines for Implementing New Capital Adequacy Frameworkcovering the capital adequacy guidelines of the Basel II accord. RBIhad also specified that the migration to Basel II will be effectiveMarch 31, 2007 and has suggested that banks should adopt thenew capital adequacy guidelines and parallel run effective April 1,2006. Over time, when adequate risk management skills havedeveloped, some banks may be allowed to migrate to the InternalRatings Based approach for credit risk measurement.


20/29

Risk Management Norms: The Basel II norms for capital adequacyconcentrate heavily on risk management systems (RMS). Basel IIaddresses credit risk as well as operational risk. Credit risk

estimates the potential loss because of the inability of counter-partyto meet its obligation. On the other hand, operational risk resultsfrom errors that can be made in instructing payments or settlingtransactions. Basel II requires the banks to have a CAR(capital adequacy ratio) of 12.5%. Most banks do not have this levelof CAR. To increase their capital base, the banks have to raise new

funds through various sources. That is why we are seeing the rushof banks to the capital market.

Disclosure Norms: As a move towards greater transparency,banks were directed to disclose the following additional informationin the 'Notes to Accounts' in their balance sheets (i) maturity patternof loans and advances, investment securities, deposits andborrowings, (ii) foreign currency assets and liabilities, (iii)movements in NPAs and (iv) lending to sensitive sectors as definedby the Reserve Bank from time to time.


21/29

Supervisory Measures: 1) Establishment of the Board for FinancialSupervision as the apex supervisory authority for commercial banks,financial institutions and non-banking financial companies. 2)

Introduction of CAMELS supervisory rating system, move towardsrisk-based supervision, consolidated supervision of financialconglomerates, strengthening of off-site surveillance through controlreturns. 3) Recasting of the role of statutory auditors, increasedinternal control through strengthening of internal audit. 4)Strengthening corporate governance, enhancing due diligence onimportant shareholders, fit and proper tests for directors.

Technology Related Measures: Implementation of technology isimportant as technology helps banks to reduce transaction cost andtime. The banks, in turn, can then pass the benefit on to customersby slashing service charges and most importantly: giving speedyservice. The other benefits are faster branch reconciliation and as a

result reduced hassles in the banks internal functioning too.(Examples are CBS, RTGS etc in trading of Govt. Securities.)


22/29

PRUDENTIAL REGULATIONS

There are 2 models for bank regulation: economic regulation andprudential regulation. Economic regulatory model involves issues like constraints on interest rates,

tightening entry norms and directed lending etc. The method was extensivelyfollowed by the RBI in the pre-reform period but evidence indicates that themodel hampered the productivity and efficiency of banks. Hence RBI adopted

Prudential regulation Prudential Regulation it calls for imposing regulatory capital level to maintain

the health of banks and soundness of the financial system. It allows greater playfor market forces than economic regulatory model

RBI issued prudential norms based on the NC Report.

Prudential Norms strive to ensure: Financial Safety

Soundness and Prudent business without excessive risk taking

Solvency of Banks

Banking reforms were initiated by implementing Prudential Norms

consisting of CAR; Asset Classification; Income Recognition & Provisioning.This has ever-since been broadened as per international standards.


23/29

Capital Adequacy

Banks are required to maintain unimpaired minimumcapital funds equivalent to the prescribed ratio on theaggregate of risk weighted assets and other exposures.

CAR is a measure of the amount of banks capitalexpressed as a % of its risk weighted credit exposure.

The capital framework was introduced for Indian SCBsbased on Basel Committee proposals (1988), whichprescribes 2 tiers of capital for the banks: T-I & T-II


24/29

Tier I capital: T-I Capital is the one which absorbs losses without a bank being required to

cease trading and T-II capital is the one which absorbs losses in the event of

winding up.

Tier 1 capital, the more important of the two, consists largely of shareholders'equity. This is the amount paid up to originally purchase the stock (or shares) ofthe Bank (not the amount those shares are currently trading for on the stockexchange), retained profits and subtracting accumulated losses. In simple terms,

if the original stockholders contributed $100 to buy their stock and the Bank hasmade $10 in profits each year since, paid out no dividends and made no losses,after 10 years the Bank's tier one capital would be $200.

Regulators have since allowed several other instruments, other than commonstock, to count in tier one capital. These instruments are unique to each nationalregulator, but are always close in nature to common stock. These are commonly

referred to as upper tier one capital. In India they include:

Paid up capital, Statutory reserves and share premium

Capital Reserves (only surplus from sale of assets), Other disclosed free reservesminus equity investments in subsidiaries, intangible assets, losses in the current period,and those brought forward from previous year.

The most permanent and readily availablesupport against unexpected losses


25/29

Tier II capital is secondary bank capital that includes items such asundisclosed reserves, general loss reserves, subordinated termdebt, and more: Undisclosed Reserves & fully paid up cumulative perpetual preference shares

Revaluation Reserves (arising out of Revaluation of assets)

General Provision and loss reserves

Hybrid debt capital instruments

Subordinate debt that is fully paid up

Tier II capital:

Capital Adequacy Norms: (CAR)

CAR is the measure of the amount of a banks capital expressed asa % of its risk weighted credit exposures.

As per the BASEL accord of 1988 the following principles of capitaladequacy were suggested: A bank must hold equity capital at least 8% of its assets when multiplied by

appropriate risk weights. The four risk weights suggested by the Baselcommittee were 0%, 1.6%, 4% and 8% for various categories of assets.

When capital falls below the min requirement, shareholders may contribute theloss by recapitalising or else the regulatory authority may liquidate the bank


26/29

Initially RBI directed banks to maintain a minimum CAR of 8% on the riskwtd assets.

The committee on Banking Sector Reforms (1998) suggested a furthertightening of the CAR to 9% by march 00

As on March 02 all SCBs (except 5) recorded CAR in excess of 9% but by2005-2006 only 2 old pvt sector banks were defaulters.

Basel Capital Accord The bank for international settlement (BIS) is an international organisation

which fosters international monetary and financial co-operation and servesas a bank for central banks.

The Basel Committee established by the Central Bank Governors of thegroup countries at the end of 1974, meets regularly 4 times a year. It hasabout 30 technical work groups and task forces.

India is a member of the G-20 and advises the financial stability forum(FSF). The Core Principles Liaison Group set up by Basel Committee onBanking Supervision (BCBS) discusses proposals for revising the capitaladequacy framework.

BACKGROUND: Different CBs have different norms in their respectivecountries but to provide a level playing field the group of 15 most industrial

countries agreed on some common rules which came to be known as BaselAccord.


27/29

New BC Accord The norms laid down in 1988 helped to arrest the

erosion ofbanks capital ratios. But were not found to beadequate due to their perceived rigidities. Moreover withthe passage of time the Financial Markets, FinancialIntermediaries, Banking business, Risk Managementpractices have undergone significant changes.

These baseline capital adequacy norms were found tobe inadequate as they almost entirely addressed creditrisk. Therefore BCBS (banking spv) brought out arevised capital adequacy framework in june 99 with a

second revision on Jan 01 effective from Jan 2005.

The primary objective of the new accord are: (i)promotion of safety and soundness of the fin sys (ii)enhancement of competitive equality (iii) constitution of a

more comprehensive approach to address risk.


28/29

The new Basel Accord is based on threemutually reinforcing pillars:

Minimum capital requirement

Supervisory Review Process

Market Discipline

Minimum capital requirement: New framework maintains both thecurrent definition of capital and minimum requirement of 8% of cap torisk wtd assets.

Basel II has recommended 3 approaches:

Standardised Approach

expands the scale of risk wts and usesexternal credit rating (less complex banks)

The foundation internal risk based (IRB) approach - banks withmore advanced risk mgt capabilities with strict methodologiesand disclosure standards.

Advanced internal risk based (AIRB) approach - it takes into a/coperational risk as well


29/29

Supervisory review process: The supervisors would be responsiblefor evaluating the way the banks are measuring risk and robustnessof the system and processes.

The 4 basic and complementary principles are: Ability of assessing its overall CAR to its risk profile + strategy to maintain its

capital level

Supervisors should review and evaluate the banks internal capital adequacyassessment and strategy and its compliance with regulatory ratios

Supervisors expect banks to operate above the min regulatory capital ratios.

Supervisors should seek to intervene at an early stage to prevent capital fromdipping bellow prudential levels

Market Discipline: It can be bolstered through enhanced disclosuresby banks. It provides several areas for disclosure:

Maturity pattern of deposits, borrowings, investments, advances, foreigncurrency assets, liabilities, movements in NPA, lending to sensitive sectors, totaladvances against shares, total investment made in equity shares, convertibledebentures etc.

banking sector reform (2)

Documents