banking sector reforms in indian economy

7/29/2019 banking sector reforms in indian economy

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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.

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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 forces due to the deregulated interestrates. 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 first time that Indianpublic 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.

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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.

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.

TABLE OF CONTENTS

CH.NO. TITLE

PAGE NO

CHAPTER - 1 REFORMS IN THE INDIAN BANKING SECTOR

1.1 Introduction 01

1.2 Reduction of SLR and CRR 04

1.3 Minimum 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

1.8 Restructuring 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

CHAPTER - 2 DEVELOPMENTS IN THE INDIAN BANKING SECTOR

2.1 Introduction 42

2.2 Voluntary Retirement Scheme 43

2.3 Universal Banking 52

2.4 Mergers and Acquisition 56

2.5 Banking and Insurance 62

2.6 Rural Banking 65

2.7 Virtual Banking 71

2.8 Retail Banking 73

CHAPTER 33.1 The SCAM Story 74

3.2 Public Sector OR Private Sector Point of

Views 76 3.3 And today... the

news say. . . 83

3.4 Future whats ahead 86

4

CH.NO. TITLE

PAGE NO


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3.5 Conclusion 88

List of Illustrations and Visual Aids

Illustration

No.

Title Page no.

12

3456

78910

Trends in CRR and SLRGrowth In Investments In GovernmentSecurities by BanksClassification of Loan Assets of SCBsIndian Banks: Trend in ROECapital Contributed by GovernmentIncome and Expenses Profile of banks

VRS trends in BanksICICI pre merger and post mergerscenarioComparison of classes of banksLendings in Rural India

610

15223741

50606170

List of Annexures

Annexure 1: List of banks 90

Annexure 2: Questionnaire 93

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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 the

deregulation 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

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

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1.1 Introduction


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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 loans

ix. 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 10national 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

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

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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

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

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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 monthsvi.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

xiii. There is need to institute an independent loan review

mechanism especially for large borrowal accounts to identifypotential 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 itsincome 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);

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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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REFORMS


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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

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

11

1.2 Reduction of SLR andCRR
http://www.asci.org.in/publications/ascijl/v24/v24_2_moh.htm#Reserve%20Bank%20of%20Indiahttp://www.asci.org.in/publications/ascijl/v24/v24_2_moh.htm#Reserve%20Bank%20of%20India


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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:

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.

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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

14

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

Percentage

ofDTL

SLR CRR


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Illustration 1

The committee recommended a Stipulation of minimum capital adequacy

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

Statutory Reserves

Disclosed free reserves

Capital reserves representing surplus arising out of sale

proceeds of assets

Tier-II Capital, comprising of

Undisclosed Reserves and Cumulative Perpetual Preference Shares

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1.3 Minimum Capital AdequacyRatio


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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 thebanks 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.

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

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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 the

public 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 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 forcea 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

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respond to positive as well as negative changes in the economic

environment. 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 severalattendant problems' The situation is complicated by the fact that " private

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

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

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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.

Growth In Investments In Government Securities by Banks

1991-

92

1992-

93

1992-93

[Up to Jan

93]

1993-94

[Up to Jan

94]

Aggregate deposits growth

36441

[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.

The Narasimham Committee II, 1998, suggested further revision i.e. CAR

to be raised to 10% from the present 8%(1998); 9% by 2000 and 10% by

2002

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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 netNPAs (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.

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

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1.4 Prudential Norms


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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 greater

transparency 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

becomes essential 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

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.

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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.

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

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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

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 onNPAs 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-

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

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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 SCBsA. 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

E. TotalAssets (Rs. Crore)

1997-98 284971 36753 30972 352696

1998-99 325328 43049 31059 399436

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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

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.

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Illustration 3


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A provision of 1% on standard assets is required as 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. To the extent that provisions have

not been made, the profits would be fictitious.

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 the taxpayers money

given to the banks as capital is not used to write off private loans without

adequate efforts and punishment of defaulters.

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# 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 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 with

necessary 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

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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

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.

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. Individual

companies 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

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

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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, to

denationalise 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.

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

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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 these

banks 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

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 the

race.

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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.

Convergence-The new private banks are able to provide a

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

based revenues.

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Illustration 4

Annexure 1

List of Banks operating in India.

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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pledged 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 Supremecourt 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 ANDBANKERS 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

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

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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 the

recovery of debt, putting to rest all doubts on that score.

SOME MORE ISSUES

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

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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 telling

commentary 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).

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

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The major recommendations/points of the Working Group, which

submitted its Report in October, 1999, are listed below:-

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

41

THE VERMA PRESCRIPTIONa brief

Identification of weak banks by using benchmarks for 7critical 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-making

foreign branches

Transfer of non-performing assets to an Asset ReconstructionFund

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

Independent Financial Restructuring Authority to monitorimplementation of revival package


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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.

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

compromises for 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 provided

by 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.

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

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

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

less risky 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 down

800 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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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 measurethe 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 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

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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 the

issues 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:

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 the

working of the client company. On the basis of this appraisal the borrower

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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

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. The

finalguidelines 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 theyshould 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

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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

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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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.

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

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1.10 Reduction of Government Stake


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equity to 33 per cent

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 to

amend 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.

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

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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

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 despite

proposed relaxations.

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

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

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 50

per 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 marketeasily. 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

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 ?

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Union parliamentary affairs minister Pramod Mahajan said:

The amendment is an enabling provision. We are only making it

easier 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?

The Indian Banks' Association had, in its memo to the committee, called

for 100 per cent divestment of the government stake. Banks should be

allowed to access 100 per cent capital from public, either from the

domestic or international capital markets. This will increase the

accountability of banks to shareholders.

Employees of the public sector banks went on a token strike on 15

November, protesting against the governments policy of privatisation of

public sector banks. It was as usual, reported that the strike was total and

successful. The inconveniences caused to millions of customers,

unconnected with the issues involved, went unnoticed, though one or two

TV channels interviewed a couple of people, who could not articulate their

views properly.

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Who is afraid of


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From 1992-93 to 1998-99, the government has injected into the 19 public

sector banks, an amount of Rs.20,446 crore as additional capital. Of this,

three banks-UCO Bank, Indian Bank and United Bank of India, have

received Rs.5729 crore

Capital Contributed by Government

BankCapital Added [Rs in

Crores]

Allahabad Bank 90

Andhra Bank 150

Bank of Baroda 400

Bank of India 635

Bank of Maharashtra 150

Canara Bank 365

Central Bank of India 490

Corporation Bank 45

Dena Bank 130

Indian Bank 220

Indian Overseas Bank 705

Oriental Bank of

Commerce50

Punjab National Bank 415Punjab & Sind Bank 160

Syndicate Bank 680

UCO Bank 535

Union Bank of India 200

United Bank of India 215

Vijaya Bank 65

Total 5700

Source: Reserve Bank of India Bulletin [1994].

Illustration 5

THE STATE BANK STORY

The demand for funds by the SBI is even more acute than even the

Corporation Bank since the SBI Act provides for a minimum 55 per cent

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RBI holding in SBI, and the bank is already close to breaching this

threshold. The immediate beneficiary of this move would be Corporation

Bank where government equity is down to 66 per cent. The bank would be

able to access funds from the market without being hampered by the 51

per cent minimum government holding threshold, which currently limits

the ability of banks to expand beyond a certain level. Since a decision on

the new threshold has been taken in the case of the nationalised banks,

the government is expected to follow suit by moving an ordinance to

reduce the RBI stake in the SBI to 33 %

The issue of reducing government stake in the nationalised banks has

come about on account of demand from the SBI which had demanded

that either RBI as the stakeholder pump in funds for the SBIs massive

expansion plans or permit it to issue shares to the public to raise the

necessary funds.

Both the Banking Regulation Act and the SBI Act provide that government

shares cannot be divested and since the government has decided that it

would no longer support banks through budgetary support, they have nooption but to go to the market to meet their fund requirements.

Though there is no special significance attached to the 33 per cent

threshold in the Company Law which recognised only 26 per cent and

74 per cent as two major thresholds for management and ownership

control the government has opted for 33 per cent on the basis of the

recommendations of the Narasimham Committee. The committee had felt

that this threshold would provide comfort to the employees. The banks,

like insurance companies, have strong unions and, hence, a phased

reduction in government equity was recommended.

The State would continue to be the single largest shareholder in banks

even after its stake had been brought down to 33 per cent.

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The government is also proposing to move an ordinance for demerger of

four subsidiaries of GIC. The law ministry has already cleared both

proposals of

banking sector reforms in indian economy

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