Financial Institutions & Banking

Assignment

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Q1. Describe the functions performed by the financial system?

ANS)

The Financial System

The financial system consists of the markets, intermediaries, service firms, and other institutions that help carry out the financial decisions of households, business firms, and Governments. Financial intermediaries are defined as firms whose primary business is to provide financial services and products to end users of these products. They do not use or provide funds directly but channel them from agents with a surplus of funds to those with a deficit. Financial intermediaries include commercial and investment banks, investment companies, venture capital firms, and insurance companies. Their products include checking accounts, commercial loans, mortgages, mutual funds, information services, and a wide range of insurance contracts.

The financial system can be broadly classified into regulated and unregulated market. The regulated financial market has supervision and control and systems governed by the central bank of the country, treasury or government. In contrast, the unregulated financial market lack recognition of transactions and are subject to risk.

Central banks primary function is to promote public policy objectives by influencing certain financial market parameters such as the supply of local currency. A country has at most one central bank.

The central bank is part of the government but can be relatively independent of the executive body of government (semi-autonomous). It is at the heart of a country’s payments system and its main responsibility in most countries is to maintain price stability. The variety of financial institutions reveals the complex requirements of both borrowers and lenders. Banks, building societies, investment trusts and pension funds are just a few of the organizations whose job it is to channel funds to those that require them. These institutions operate in the short-term (money) market and the long-term (capital) market. In the money market, the main activity centers around funds, which are lent for periods from as short as overnight up to about one year. The capital market focuses on money borrowed and lent for periods of five years or more. There is a grey area, of one to five years that is not incorporated into the two definitions and hardly surprisingly this is called the medium-term market.

The Indian financial System can be broadly classified as under:

Reserve Bank of India at the apex

Commercial banks: Commercial Banks comprise public sector banks, foreign banks and private sector banks represent the most important financial intermediary in the Indian financial system.

Developmental Financial Institutions: Since independence, a large number of financial institutions have been set up with the sole purpose of catering to the long-term financial needs of the industrial sector. The structure of financial institutions comprises of all India long term financing institutions (Industrial Development Bank of India, Industrial Finance Corporation of India and Industrial Credit and Investment Corporation of India), State Financial Corporations and State Industrial and Development Corporations. Due to the importance of the small-scale sector, the Government set up the Small Industries Development of India in July 1989.

Insurance Companies: The insurance sector is broadly controlled by two public sector companies-the Life Insurance Corporation of India and the General Insurance Corporation of India which is a holding company that has four fully owned subsidiaries in its fold. With the liberalization of the insurance sector, several private players have also entered the insurance field.

Other Public Sector Financial Institutions: A variety of Public Sector Financial Institutions exists. The important ones are Post Office Savings Bank

Post Office Savings bank: Run by the Post and Telegraph department the POSB is operated through the vast network of post offices.

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National Bank for Agriculture and Rural Development: The bank is the apex bank for agricultural financing and channelises the assistance through various regional, state level and field level institutions like the Regional Rural Banks, State Cooperative Banks etc.

Mutual Funds: A mutual fund is a collective investment arrangement, which has following three important entities at its core - the sponsor, the trust and the asset management company. The sponsor floats the mutual fund, which is organized as a trust except when it has been set up by law such as UTI. The organization floats a number of schemes for the public to participate. The asset management company manages the funds that are so mobilized under the various schemes.

Non-Banking Finance Corporations: During the mid - eighties many non - banking financial companies were set up in the public as well as the private sector. Some of the well-known companies are SBI Caps, Kotak Mahindra Finance, Sundaram Finance and Infrastructure Finance and leasing Corporation. They engage inn a variety of fund based and non-fund based activities. The principal fund based activities are leasing, hire purchase and bills discounting. The main non-fund based activities are issue management, corporate advisory services, loan syndication and forex advisory.

The Role of the Financial System

We can identify the following basic functions performed by the financial system:

1. To facilitate the transfer of economic resources through time, across borders, and industries: Financial transactions often involve giving up something now in order to get something in the future, or vice versa. Examples of this are student loans and retirement savings. The financial system also allows resources to flow from one country to another.

2. To allow the management of risk, i.e. transfer resources across “states of nature”: As the future is uncertain, one might want to shift resources from “good” periods or outcomes to “bad” periods or outcomes. Insurance companies are financial intermediaries that specialize in the activity of risk transfer. They collect premiums from customers who want to reduce their risk and transfer it to investors who are willing to bear the risk to pay the claims if necessary in return for some reward.

3. To provide ways of clearing and settling payments to facilitate trade: An important function of the financial system is to provide an efficient way for people and businesses to make and receive payments when they wish to trade goods and services. For instance, the convenience of using travelers’ checks or credit cards when traveling internationally.

4. To pool resources and subdivide ownership in various enterprises: The minimum investment required to run a business is often beyond the means of an individual or even a large family. The stock market and banks facilitate the financing of large projects by pooling resources and aggregating the wealth of households into larger amounts of capital.

5. To provide price information to help coordinate decentralized decision making in various sectors of the economy: Every day we receive information about stock prices and interest rates. Only few of us actually buy and sell securities frequently. Nevertheless, many people use the information generated by and contained in security prices to make other types of decisions. Whether one want to buy a house or rent is influenced both by the current and expected future levels of interest rates and house prices.

6. To provide ways of dealing with the incentive problems created when one party to a transaction has information that the other party does not or when one party acts as agent for another.

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Q2. What are the functions of the RBI and briefly comment on the changes adopted by the RBI while announcing the Monetary and Credit Policy since liberalization?

ANS)Reserve Bank of India (RBI)

India's Central Bank - the RBI - was established on 1st April 1935 and was nationalized on 1st January 1949.

The Preamble prescribes the objective as:

"To regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage."

The RBI as central bank of the country is at the centre of the entire monetary system. As the apex bank, it has been guiding, monitoring, regulating and promoting the destiny of Indian financial system. It is the oldest amongst the developing countries.

The main functions of RBI are:

Monetary Authority: RBI formulates, implements and monitors the monetary policy to maintaining price stability and

ensures adequate flow of credit to productive sectors.

Regulator and supervisor of the financial system: RBI prescribes broad parameters of banking operations within which the country’s banking and

financial system functions. The objective is to maintain public confidence in the system, protect depositors’ interest and provide cost-effective banking services to the public.

The RBI also has certain non-monetary functions like supervision of banks and promotion of sound banking in India. The RBI ACT, 1934 and the Banking Regulation ACT, 1949 has given the RBI wide powers of supervision and control over commercial and cooperative banks relating to granting of licenses for starting new banking organizations, branch expansion, liquidity of their assets, etc,. The RBI is authorized to carry out these supervisory functions periodically

Manager of Exchange Control: RBI manages the Foreign Exchange Management Act, 1999. The RBI has the responsibilityto maintain the official rate of exchange. Besides maintaining the rate of exchange of rupee, the RBI acts as the custodian of India's reserve of international currencies. Further the RBI has the responsibility of administering the exchange controls of the country.

Objective: To facilitate external trade and payment and promote orderly development and maintenance of

foreign exchange market in India. To set limits in foreign exchange in tune with the supply and reserve of a particular currency.

Issuer of currency: RBI issues and exchanges or destroys currency and coins not fit for circulation. Under Sec.22 of the

RBI Act, the bank has the right to issue notes of all denominations. The distribution of 1 Re. Notes and small coins of all denominations is also undertaken by the RBI, as the agent of the Government. The RBI has a separate issue department, which is entrusted with the issue of currency notes. The issue department issues notes on the basis of Minimum Reserve System. The Objective is to give the public adequate quantity of supplies of currency notes and coins and in good quality.

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Developmental role Performs a wide range of promotional functions to support national objectives: The major function of

RBI is adopting the developmental role in the country's economy and thereby strengthening the financial system of an economy and offering promotional services.It has continuously worked for integration of various financial intermediaries, both in the organized and unorganized sectors, thereby inducing more discipline in the system on the one hand and meeting the progressive targets set by the Government for country's economic development.

The RBI also performs developmental functions. The RBI has taken steps to promote Banking habits among people, establish and promote new financial agencies. Accordingly, the RBI helped in setting up of the IFCI and SFC. It assisted in the setting up of the UTI in 1964 and the Industrial Reconstruction Corporation of India in 1972. The RBI also set up the Deposit Insurance Corporation. These institutions were set up to promote savings habit among the people. The objective was also to mobilize the savings and make it available to the industry for investment purposes.

Related Functions Banker to the Government: It performs merchant banking function for the central and the state

governments. RBI acts as the Government's banker, agent and adviser. The RBI transacts Government's business, keeps cash balances of the Government as deposits and receives and makes payments on behalf of the Government. They facilitate Government borrowings and manage the public debt of the Government.

Banker to banks: It maintains banking accounts of all scheduled banks and controls volumes of reserves of all commercial and co-operative Banks. As the lender of the last resort, the commercial banks can borrow from the RBI on the basis of eligible securities or get financial accommodation in times of need or rediscount bills of exchange. It also maintains the Cash Reserves and other Reserves of the commercial banks as per the Variable Reserve requirements (CRR & SLR). The RBI also comes to the rescue of the banks during times of crisis.

The other main functions of the Reserve Bank of India are to:

Maintain financial stability and enable the growth of sound Financial Institutions. This should, in turn, enable monetary stability and allow economic units to carry out their business with confidence.

Maintain monetary stability for the business and economic life towards growth and proper functioning of a mixed economic system in the country.

Maintain a stable payments and currency system and facilitate safe and efficient execution of financial transactions.

Promote a stable financial structure of markets and systems and help it to operate with optimum efficiency

Regulate the money and credit supply in the economy to help maintain price stability to a reasonable extent.

Ensure credit allocation in line with national economic priorities.

MONETARY POLICY

Monetary policy refers to the use of instruments within the control of the Reserve Bank of India, to control the money supply and influence the aggregate demand for goods and services in different sectors in the economy. Monetary policy operates through varying the cost and available of credit. The modern economy is regarded as a credit economy. Credit forms a very important component of the money supply of the economy. The variations in metallic money and credit money affect the demand for and supply of credit in the economy.

Demand deposits are a very important constituent of the money supply. In advanced countries like US, it forms three fourths of money supply. In India, demand deposits constitute about 50% of the money supply today. Over three decades ago, they formed only 25%. In underdeveloped countries, in general, the proportion of the demand deposits as a constituent of money supply is small. The level of economic development, the extent of

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development of banking infrastructure and the banking habits of the people, play an important role in determining the extent of demand deposits. It has already been pointed out that banks create active deposits, when they extend credit to their clients.

Central banking instruments of control operate by varying the cost and availability of credit. The availability of credit to the public depends upon the Reserves - the CRR and the SLR. The regulation of credit by the Reserve Bank in essence thus means regulation of credit of the reserves of banks.

Instruments of monetary policy

The instruments of monetary policy (or the methods of credit control) can be broadly divided into I. Quantitative methods (general methods) and

II. Qualitative methods. (Selective methods)

Quantitative methods

The quantitative methods affect the total quantity of credit and affect the economy generally. The selective methods on the other hand affect certain select sectors. Here, certain distinctions are made between various sectors in the economy and are selectively applied to regulate the flow of credit to those specific sectors.

The statutory basis for the regulation of credit in India is embodied in the Reserve Bank of India Act and the Banking Regulation Act. The former Act confers on the RBI the usual powers available to any Central Bank, while the latter confers powers on the RBI to monitor and regulate the operations of the commercial banks and the cooperative bank.

There are three general or quantitative instruments of credit control, namely the Bank Rate, Open market operations and Variable Reserve requirements. All these three instruments affect the level of bank Reserves. Open market operations and the Reserve requirements directly affect the reserve base, while the bank rate increases the cost of acquiring the reserve. The objective of monetary policy have been price stability, effective usage of available resources, controlled expansion of bank credit, promotion of fixed investment, restrictions of inventories, promotion of exports, food procurement operations and equitable distribution of credit.

Q3. Identify the problems faced by Development Finance Institutions and suggest remedies to overcome them.

ANS)

Development Finance Institutions (DFIs) came into prominence after the Second World War when many developed and newly independent developing countries adopted national policies and plans for rapid industrial and agricultural development. A basic underlying principle was that long-term resource allocation should be undertaken through business-oriented financial institutions rather than by direct allocation by the government (Note: commercial banks were not up to the task because of the short-term nature of their lending activities). Thus, there was a proliferation of DFIs all over the world in the late forties, fifties and sixties.

In the late seventies and eighties, with an international movement towards globalization of trade, open economies, liberalization of the financial sector and the problems that DFIs suffered during the oil and debt crises, major changes happened to the DFIs. Many of them, faced with financial difficulties, had to either restructure themselves, merged with other financial institutions or wind up. Some, however, through the help of their governments, have successfully overcome the transition and have flourished up till today, proudly weathering the Asian financial crisis of 1997 by learning 'through their past mistakes'.

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During the turbulent years of the eighties, with soaring non-performing loans (NPLs) brought about by foreign exchange risk exposure of their borrowers, DFIs in the region, through their governments' support, have assisted in setting up statutory bodies to handle 'distressed' projects and to coordinate the different stakeholders together in working out loan restructuring programs. These 'bank hospitals' were tasked to ensure the timely detection of 'sick' and 'potentially sick' companies involved in industrial activities as well as to the speedy determination of the preventive, remedial and other measures needed to be taken with respect to such companies.

In India, the government constituted the Board for Industrial and Financial Reconstruction (BIFR) in May of 1987 under the provisions of the Sick Industrial Companies Act (SICA) of 1985, recognizing that industrial firms to go through periods of good fortune and bad. Developed countries call this phenomenon as 'corporate bankruptcies' or 'corporate insolvencies.'

Although there were problems in implementation, the BIFR which was conceived as a facilitating unit to prepare and undertake restructuring schemes, has served three key contributions:

a) all 'sick' companies in the country have been registered and knownb) many non-viable companies were ultimately wound up and

c) various stakeholders and government agencies were brought together on one platform to seriously find ways and means to rehabilitate 'sick' companies.

Growing competition from other financial intermediaries, a harsher environment for corporate and withdrawal of concessional funding have left DFIs most vulnerable. Banks such as SBI have been able to venture into the domain of the DFIs armed with low-cost deposits.

On the other hand, the forays of DFIs into the domain of banks have been handicapped by the lack of access to low-cost deposits. In this environment, universal banking that includes the likelihood of a reverse merger with ICICI Bank has for long been a strategy proclaimed by ICICI.

The biggest hurdles that the merger is likely to face are smoothing the difference in regulatory requirements between commercial banks and DFI, and convincing shareholders.

Over the years, the DFIs have been nurtured and developed by active Government support, especially in the form of concessional finance. However, active Government intervention in the functioning of the DFIs has also resulted in lack of operational flexibility and competition among these institutions. To remedy the situation, we need to have a two-pronged effort. On the one hand, the DFIs should be given adequate autonomy in matters of loan sanctioning and internal administration. On the other hand, the DFIs should be made to operate in a more competitive environment. For the latter, the privileged access of the DFIs to concessional finance through SLR and other arrangements should be gradually reduced. Instead the DFIs should obtain their resources from the market on competitive terms. In addition, the present system of consortium lending by the DFIs should be discouraged. Besides other things, this would require that the present system of cross holding of equity and cross-representation on the Boards of the DFIs are done away with. “Most of the banks have been cherry-picking when it comes to offering loans to various entities but a DFI more or less has to look at the industrial development of the country and it cannot cherry pick, which in turn often leads to other problems,” Government must have a concrete plan for DFIs, which are primarily into term lending, which banks are not. The government also has already indicated that it may reconsider the merger proposal of IFCI with Punjab National Bank (PNB), announced by the NDA government.

The government divestment is also happening and this money will move to the infrastructure projects. The inflow into the infrastructure projects will create demand for the steel, cement, coal and other commodities. The current upsurge in the commodity sector herald’s good news for the development financial institutions (DFIs).

One needs a bit of historical perspective for the bullishness on DFIs. The early 90s were the heydays of the IPOs and the DFIs were at the forefront on this boom. The IPO boom also coincided with the upturn in the

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cyclical sectors. India was on the throes of liberalization, infrastructure was expected to take off in a big way, and India also had a goldmine of a market for MNCs to sell their products. All this had created a bullish fervor cutting across all sectors. New capacities were set up in the commodities sector- the then mainstay of the Indian economy. Capacities were augmented in existing plants. Most of these projects were funded by the big three viz. - ICICI, IDBI, IFCI. The funding came either as debt in the form of term loans or as equity with the DFIs picking a stake in these companies.

The infrastructure development never materialized and demands projections went haywire. There was overcapacity coupled with a falling demand. Prices fell considerably due to this imbalance. With duties falling, the actual impact was even worse. This created cash flow problems for many players and made many projects unviable. The new players got into a tangle as by the time they started commercial production after the gestation, the market realities had changed. Many of them defaulted on their debt and this saddled the FIs with Non Performing Assets-NPAs. The stock marked crashes, due to fundamentals as well as scams, made the equity of these companies worthless. So as a result, the DFIs were stuck with poor quality papers at both ends- debt as well as equity. We are on the verge of the next commodity upswing. During commodity upswing, entire sectors move forward. All companies perform well relative to the recent past. As a result, the cash flow position of these companies improves. They will be able to repay loans thereby reducing NPAs and improving asset quality of the DFIs. They are expected to rally in the bourses too, enabling the DFIs to cash in and get rid of the paper they are stuck with.

In short, this presents a great opportunity to the DFIs to cleanse their past sins and get their act together. And soon, DFI will be synonymous with Definite Financial Improvement. DFIs are different than other financial institutions, and those differences create special challenges, tensions, opportunities, and responsibilities. First, in a DFI growth and change occur within a self-consciously normative framework—a moral imperative to confront poverty and the social isolation of the poor. Doing business within such a normative framework is harder than doing business within a standard corporate framework. In the standard corporate framework, the customer is important in an instrumental way, as a buyer of a product, thus fulfilling the corporation’s goal. In a DFI the reverse is true—our product is the instrument for the customer’s goals, and our job is to help unleash the financial and social capacity of poor people.

DFIs exist in the first place because of the disconnection between conventional finance and low-income people. For the poor that disconnection amounts to a credit vacuum, and exists for familiar reasons: the elite culture of traditional financial institutions; perceptions of the poor as too risky; lack of information and systems for reaching the poor; inadequacies in regulatory and legal systems, and so on. In bridging that gap between capital markets and low-income borrowers, DFI leaders face a tension between being demonstration institutions that lead the way to more mainstream access and forms of commercialization, and our own ambition to be de novo replacement institutions that will continue to play a capital access role for a very long time. We ask if we can be both a bridge and a replacement institution.

DFIs live and work in the context of a development industry where there are relatively few truly independent institutions. Thus the challenge for DFIs of creating institutions that are stable and have a long-term perspective, in the midst of short-term oriented, less reliable growth and change occur systems, creates both financial and sometimes political risks. The art of building institutional permanence involves not just good performance but also the ability to manage within a complex political and organizational context.

Concluding remarks

Rehabilitation of 'sick' companies is a complex exercise and involves a large number of issues. No single body can undertake such a challenging task. The most important aspect of any restructuring scheme is its proper and timely implementation. Therefore, monitoring and following up of these schemes are absolutely essential.

In a parallel manner, sovereign debt restructuring is not at all an easy task. There are many stakeholders involved with varied interests. Any delay in 'coming into terms' spells difficulties for a country. Thus, initiatives for a more organized and less costly debt restructuring and dispute resolution is always a welcome development especially to developing economies and those in transition which are likely to be exposed to debt problems due

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to certain inherent weaknesses. Coupled with new and innovative contractual modifications in debt instruments and a more clarified official financing is something to look forward to. But like the experience of the Indian corporate restructuring body, not a 'fix-all, cure-all' structure and aims to compliment other 'tools' already existing and available.

Q4. What are the different kinds of banks and what is the difference in their operational methodology, purpose etc.?

ANS)

India has an extensive banking network, in both urban and rural areas. All large Indian banks are nationalized, and all Indian financial institutions are in the public sector. The banks in India can be classified under following categories:

Category 1 -Public Sector banks (also referred to as "nationalized banks"), which are commercial and scheduled. Examples: State Bank of India, Bank of India etc.

Category 2 - Private Sector banks, which are commercial and scheduled. These could be foreign banks as well as Indian Banks. Examples: Foreign Bank - CITI Bank, Standard Chartered Bank etc. Indian Bank - Bank of Rajasthan Limited, VYSYA Bank Limited etc.

Category 3 - Private Sector banks, which are co-operative and scheduled. These are large co-operative sector banks but which are scheduled banks. Examples: Saraswat Co-operative Bank Limited, Shamrao Vithal Co-operative Bank Limited, Cosmos Co-operative Bank Limited etc.

Category 4 - Private Sector banks, which are co-operative and non-scheduled. These are small co-operative banks but which are non-scheduled. Examples: Local co-operative banks which operate within a town or a city, like Mahesh Sahakari Bank Limited etc.

Category 5 - Public Sector banks, which are co-operative and non-scheduled. These are state owned banks like the Maharashtra State Co-operative Bank (State level), Pune District Central Co-operative Bank (District level) and Junnar Co-operative Society etc.

Category 6 - Regional Rural Banks that are state owned and have different roles assigned to them.

Category 7 - Gramin Banks that are also state owned and have different roles assigned to them.

Retail Banking Retail banking is typical mass-market banking where individual customers use local branches of larger

commercial banks. Services offered include: savings and checking accounts, mortgages, personal loans, debit cards, credit cards, and so forth.

Retail banking is largely intra-bank; the bank itself makes many small loans.

Wholesale Banking Wholesale banking typically involves a small number of very large customers such as big

corporations and governments, whereas retail banking consists of a large number of small customers who consume personal banking and small business services.

Wholesale banking is largely inter-bank; banks use the inter-bank markets to borrow from or lend to other banks/large customers, to participate in large bond issues and to engage in syndicated lending.

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Wholesale Banking and Retail Banking

Most of the Indian public sector banks practice retail banking; they are slowly practicing the concept of "wholesale banking". On the other hand, most of the well-established foreign banks in India and the recent private sector banks practice wholesale banking alongside retail banking.

This results in the difference of composition of income for a public sector bank and a well-established private sector bank. The composition of income is comprises of commission on bills/guarantees/letters of credit, counseling fees, syndication fees, credit report fees, loan processing fees, correspondent bank charges etc. A major portion of the income for large public sector banks is from lending operations, in the case of any private sector bank in India, the amount of non-operating income, other than interest income, is substantially higher. This is considered as a healthy sign, as the investment required for earning non-interest income is negligible. Non-interest income is earned from those activities, which are fees based and therefore very little capital is required to carry on such activities.

Cooperative Banking

Co-operative Banks are organized and managed on the principal of co-operation, self-help, and mutual help. They function on "no profit, no loss" basis. Co-operative banks, as a principle, do not pursue the goal of profit maximization. Co-operative bank performs all the main banking functions of deposit mobilization, supply of credit and provision of remittance facilities.

Commercial banks are run with motive of profit of the organization. All the nationalized banks in India and almost all private sector banks are commercial scheduled banks. Accepting of deposits from the public for various purposes like lending or investment; Repayable on demand or otherwise; withdraw able by means of any instrument whether a cheque or otherwise.

Co-operative bank do banking business mainly in the agriculture and rural sector. However, UCBs, SCBs, and CCBs operate in semi urban, urban, and metropolitan areas also. The urban and non-agricultural business of these banks has grown over the years. The commercial banking structure in India consists of scheduled Commercial Banks and Unscheduled Banks. The co-operative banks demonstrate a shift from rural to urban, while the commercial banks demonstrate a shift from urban to rural.

Co-operative banks get financial and other help from the Reserve Bank of India NABARD, central government and state governments. They constitute the "most favoured" banking sector with risk of nationalization. For commercial banks, the Reserve Bank of India is lender of last resort, but co-operative banks it is the lender of first resort, which provides financial resources in the form of contribution to the initial capital (through state government), working capital, refinance.

It is interesting to note that intra-sectoral flows of funds are much greater in co-operative banking than in commercial banking. Inter-bank deposits, borrowings, and credit from a significant part of assets and liabilities of co-operative banks. This means that intra-sectoral competition is absent and intra-sectoral integration is high for co-operative bank.

Co-operative Banks are subject to CRR and liquidity requirements as other scheduled and non-scheduled banks are. However, their requirements are less as compared to commercial banks.

Since 1966 the Reserve Bank of India has directly regulated the lending and deposit rate of commercial banks. Although the Reserve Bank of India had power to regulate the rate co-operative bank but this have been exercised only after 1979 in respect of non-agricultural advances they were free to charge any rates at their discretion. Although the main aim of the co-operative bank is to provide cheaper credit to their members and not to maximize profits, they may access the money market to improve their income so as to remain viable.

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Scheduled Banks

Being the Central Banking Authority, Reserve Bank of India (RBI) monitors all the banks and other financial institutions operating in India. RBI controls the banking sector in India through an act called "The Banking Regulations Act". Previously, when there were very few banks, RBI used to include all the "scheduled" banks in its Schedule. Nowadays, when the number of banks has gone up substantially, RBI has to change the schedule every now and then. Hence irrespective of whether a bank finds its name in the schedule to the RBI Act or not, its "schedule status" can be found out from its banking license. A bank that is not a scheduled bank is referred to as "non-scheduled" bank even in its banking license.

The difference lies in the type of banking activities that a bank can carry out in India. In the case of a scheduled bank, it is licensed by the RBI to carry on extensive banking operations including foreign exchange operations, whereas, a non-scheduled bank can carry out only limited operations. There are a number of factors considered by RBI to declare a bank as a "scheduled bank", like the amount of share capital, type of banking activities that the bank is permitted to carry out etc. An example of difference between a scheduled and non-scheduled bank is dealing in "Foreign Exchange".

Q5. What is International Banking and how do banks contribute to the growth of International Business?

ANS)

International BankingInternational Banking Regulation provides a forum for analysis from leading representatives of regulation, practice and banking law. It covers the scope of banking regulation in its broadest sense, across the full field of financial services, from the protection of ordinary citizens’ savings on the one hand to the regulation of multi-national financial institutions with a taste for huge risk and high profit on the other. The last decade has witnessed the rise of the modern financial market in an economically liberal climate where the regulation of the international financial architecture, in addition to banks and their business, is of increasing importance.

International Banking Regulation provides one-stop forum to access expert analysis of international issues in banking regulation from around the globe provided by leading academics, regulators and practitioners from multi-disciplinary backgrounds including economists, accountants, bankers, compliance professionals and lawyers.

The total international liabilities of Indian banks grew by 6.68% to $37,456 million as on June30, 2002 compared to $35,110 million at the end of quarter ended March 31, 2002, according to International Banking Statistics of India. The assets of these banks grew by 3.2% to $21,440 million for the quarter ended June compared to $20,774 million as on March 31. The liabilities excluding the impact of merger in the banking sector during the reporting quarter amounted to $35,545 million. Of the total liabilities, external debt obligations stood at $27,148 million, (about 72.5%.

The liabilities on account of FCNR (B), foreign currency borrowings, Resurgent India Bonds, India Millennium Deposits and floating rate notes stood at $27.14 billion while the non-repatriable deposits base amounted $6.16 billion as on June. International loans and deposits pegged at accounted for 94.4% of asset base of banks as on June.

The concept of International Banking comes into existence when banking started transcending the national boundaries apart from the regional boundaries. International banking revolves around the following:

International trade, Tourism, Remittance of funds from one place to another place, Syndication of loans globally for large business houses and multinationals, Accessing international markets for equity/borrowing in the form of bonds etc. for corporate houses or multinationals, Foreign exchange management etc.

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International banking contribute to a major extend towards the growth of International business

International trade Letters of Credit, International Guarantees like performance guarantee, advance Money guarantee etc. Deferred Payment Credit backed by bank guarantee Bills for collection Foreign exchange involved in remittance of proceeds from the importing country to the exporting

country Tourism

International Travellers' checks International Money Orders

Foreign exchange involved in encashment of travellers' checks and International Money Orders/ Demand Drafts/Telegraphic Transfer/SWIFT remittance etc.

Credit card business and international bills settlement under credit cards Remittance of funds from one place to another place besides tourism

Routine transfer from persons employed abroad Donations/charity remittances Remittances for disbursement of loans (inward for the borrowing country) Remittances for repayment of loans (outward for the borrowing country) Remittance for payment of interest (outward for the borrowing country) Remittance of royalty, dividend (outward for remitting country)

Syndication of loans globally for corporate houses

This does not involve any funds and it is a non-fund based activity earning non-interest income. Accessing international market for equity/borrowing in the form of adr/gdr and euro bonds etc. This again does not involve any funds and it is a non-fund based activity earning non-interest income

Foreign Exchange Management

This is common to all the activities listed above, which involve funds. Such activities are called fund-based activities of the bank, unlike syndication and/or accessing international markets for GDR/ADR, Euro bonds etc., which are non-fund-based activities.

A discussion about international banking is not complete without mention of electronic cash on the Internet or "E-cash". This could easily become global currency, issued by Governments and private firms alike. The explosive growth of this phenomenon will tremendously influence globally the banking industry and hence everybody in the banking industry is watching this development with interest, awe and fear, all at the same time.

Q6. What are the different activities covered under priority sector and what are the differences in compliance requirements between Indian banks and foreign banks?

ANS)

Illustrative List of different activities of priority sector.1. Agriculture2. Advertising Agencies3. Marketing Consultancy4. Industrial Consultancy5. Equipment Rental and Leasing

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6. Typing Centres7. Photocopying Centres (Zeroxing)8. Industrial Photography9. Industrial R & D Labs10. Industrial Testing Labs11. Desk Top publishing12. Internet Browsing/Setting up of Cyber Cafes13. Auto Repair, services and garages14. Documentary Films on themes like Family Planning, Social forestry, Energy Conservation and Commercial

Advertising15. Laboratories engaged in testing of raw materials, finished products16. “Servicing Industry” Undertakings engaged in maintenance, repair, testing or electronic/electrical

equipment/instruments i.e. measuring/control instruments servicing of all types of vehicles and machinery of any description including televisions, tape recorders, VCRs, Radios, Transformers, Motors, Watches, etc.

17. Laundry and Dry Cleaning18. X-Ray Clinic19. Tailoring20. Servicing of agriculture farm equipment e.g. Tractor, Pump, Rig, Boring Machines, etc.21. Weigh Bridge22. Photographic Lab23. Blue Printing and enlargement of drawing/designs facilities24. ISD/STD Booths25. Teleprinter/Fax Services26. Sub-contracting Exchanges (SCXs) established by Industry Associations.27. EDP Institutes established by Voluntary Associations/Non-Government Organizations28. Coloured or Black and White Studios equipped with processing laboratory.29. Ropeways in hilly areas30. Installation and operation of Cable TV Network;31. Operating EPABX under franchises32. Beauty Parlours and Creches

Classification of Priority Sector and Weaker Section Advances

The definition of weaker section in priority sectors broadly corresponds to the beneficiaries under the 20-Point Economic Programme aimed at improving the standard of living of the weaker sections of the society. For classifying priority sector advances under various categories, it may be noted that the banks should not merely take into account the purpose of the loan mentioned in the borrower’s loan application but also the amount involved and should satisfy themselves that the amount borrowed would be utilized for the purpose for which it was sanctioned, by calling for documentary evidence in support thereof, wherever considered necessary.

For example, loans to small traders or small businessmen are essentially in the nature of working capital loans and they have to be given primarily against the hypothecation or pledge of the goods in which they are dealing and therefore loans to small traders or small businessmen against gold or jewellery may not necessarily be the loans for undertaking trade or business. Similarly, in the case of a loan for construction of a house, it would have to be satisfied that the borrower has the land and his construction plans bear the approval of the competent authority or he has joined some co-operative society to construct the house. Mere security of jewels coupled with indication of "housing" as purpose in the loan application should not satisfy the bank for classification of priority sector advances.

Therefore, loans against gold ornaments (jewel loans) which are in a majority of cases availed of by the weaker sections of the society, the purpose of the loan and the loan amount actually sanctioned to each borrower and not the security therefore, should be adopted as the criteria for classification of the priority sector advances and advances given to weaker sections of the society.

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Priority Sector Lending, difference in compliance requirement:Public sector banks account for more than 80 percent of India's banking activities. Regional private banks handle 6 percent and foreign banks account for about 8 percent. Gross non-performing assets of the 27 public sector banks were estimated to be 14.3 percent of total loan assets on March 31, 2001, down from 15.6 percent in 1999-2000. A Board for Financial Supervision has been established to ensure compliance with guidelines on loan management, capital adequacy, and asset classification. Domestic Indian banks are required to extend 40 percent of their loans to "priority" borrowers, the agriculture sector, exporters, and small businesses. Foreign banks are required to offer 32 percent of their loans to the non-agricultural priority sector.

SCBs have been assigned targets and sub-targets under the system of priority sector lending in order to ensure timely flow of credit to vital sectors like agriculture and SSI, and to cater to the credit requirements of the weaker sections. In the case of domestic banks (public and private), aggregate advances to the priority sector should constitute 40% of the total net bank credit (NBC). The sub-target in respect of agriculture is 18% of NBC, while that in respect of weaker sections is 10 percent. Though there is no separate sub-target for SSI, the total credit flow to SSI sector needs to conform to the stipulated distribution within SSI based on size of investment in plant and machinery. Over the years, a number of sectors/activities have been added to the priority sector in response to the changing structure of the Indian economy. The additions include housing, credit to Non-Bank Financial Companies (NBFCs) for on lending to small road and water transport operators for purchase of trucks, software units and venture capital. In the case of foreign banks, the priority sector stipulation is only 32% of NBC with a sub-target of 12% of NBC for exports and 10% for SSI.

As on the last reporting Friday of March 2001, the total priority sector advances by public sector banks accounted for 43.0% of their net bank credit (NBC), similar to the figure of 43.5% as on the last reporting Friday of March, 2000. Advances to priority sector by private sector banks constituted 38.2% of NBC on the last reporting Friday of March 2001 compared with 38.7% in the previous year. Within the priority sector, the outstanding credit to agriculture from PSBs accounted for 15.7% of net bank credit on the last Friday of March 2001 compared with 15.8% as on the corresponding date in the previous year. The corresponding figures for private sector banks were much lower at 9.6% and 9.1% in case of foreign banks. The outstanding credit from PSBs to other priority sectors comprising various activities/sectors including small scale business, retail trade, etc., had increased over time from 0.7 percent at the time of nationalization to 11.8% on the last reporting Friday of March 2001. Advances to other priority sectors from private sector banks were 14.2% on the last reporting Friday of March in 2001. On the last reporting Friday of March 2001, export% respectively, on the last reporting Friday of March 2001 and 2000. Advances from PSBs to the SSI sector accounted for 14.2 percent of NBC on the last reporting Friday of March 2001 compared with 15.6% on the last reporting Friday of March in the previous year. The outstanding credit to the SSI sector was 14.4% in respect of private sector banks on the last reporting Friday of March 2001 while it was 11.0% in the case of foreign banks. The corresponding figure on the last reporting Friday of March in the previous year was higher at 15.7% in the case of private sector banks, while it was lower at 10.2% in the credit by foreign banks accounted for 20.0% of NBC while the total priority sector advances comprising both export and small-scale industry was 34.0%. The corresponding figures on the last reporting Friday of March 2000 were 23.0% and 35.0% respectively.

Monitoring And Evaluation Of Priority Sector And Weaker Section AdvancesPrimary (urban) co-operative banks should take effective steps to achieve the above-recommended targets and monitor the priority sector lending from the quantitative and qualitative aspects.

In order to ensure that due emphasis is given to lending under priority sector, it is considered desirable that the performance is reviewed periodically. For this purpose, apart from the usual reviews, which the banks are periodically undertaking, specific reviews by the Board of Directors of the respective banks may be made on half-yearly basis. Accordingly, a memorandum may be submitted to the Board of Directors at half-yearly intervals i.e. as on 30 September and 31 March of each year giving a detailed critical account of the performance of the bank during the period showing increase/decrease over the previous half-year.

A copy of the annual review as on 31 March may be forwarded to the concerned Regional Office of the Reserve Bank with the Board's observations, indicating the steps taken/proposed to be taken for improving the bank's performance. The report should reach the Regional Office within a month from the end of the period to which it relates.

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Reporting RequirementsPrimary (urban) co-operative banks should submit on Annual Return as on 31st March each year to the concerned Regional Office of the Reserve Bank. The return should be furnished within one month from the end of the period to which it relates to the concerned Regional Office.

Member banks of State Federations may also submit a copy of the above returns to their respective federations in order to enable them to monitor their performance.

It will be return that under each item of priority sector, advances to weaker sections are also to be included.

Further, while giving the details of the position relating to advances made to different categories, viz. Scheduled castes, Scheduled tribes, women and others, care must be taken to ensure that there is no duplication in of the return indicating the position alone should be reported against the relevant columns in Part I of the return.

Register for Priority Sector/Weaker Section AdvancesIn order to facilitate compilation of the relative figures, banks may maintain a register to indicate all the items of priority sector advances and also another register for weaker section advances showing particulars, with separate folios to each activity so that the total of advances to priority sector and weaker sections under each activity and to each type of beneficiary may be available at any given point of time. The Performa of these registers may be on the lines of the annual return to be submitted to RBI as given in Annexure IV.

Targets for Foreign BanksWith a view to reducing the disparity between the domestic banks and the foreign banks operating in India in regard to their priority sector obligations the minimum lending to priority sector by the foreign banks shall be 32 percent of their net credit.

However, keeping in view that the foreign banks have no rural branch network, the composition of priority sector advances in their case will be inclusive of export credit provided by them. Within the overall target of 32 percent to be achieved by foreign banks, the advances to small scale industries sector should not be less than 10 percent of the net bank credit and the export credit should not be less than 12 percent of the net bank credit.

[The net bank credit should tally with the figures reported in the fortnightly return submitted under section 42(2) of the Reserve Bank of India Act, 1934.]

Deposit by Foreign Banks With SIDBI towards shortfall in priority sector lendingIn the event of failure to attain the stipulated targets and sub-targets, the foreign banks will be required to make good the shortfall in the achievement of the targets / sub-targets by depositing for a period of one year, an amount equivalent to the shortfall with the Small Industries Development Bank of India (SIDBI) at the interest rate of 8 percent per annum or as may be decided by the Reserve Bank from time to time.

The shortfall in achieving the priority sector lending target ad the sub-targets should be computed as on the last reporting Friday of March every year and made good by placing a deposit with SIDBI as stated above. The deposits should be placed before the end of April of that year.

In regard to the above, it is to be clarified that in the event of failure on the part of foreign banks to achieve any of the stipulated sub-targets in respect of advances to SSI sector and export credit, even if they achieve the overall target of 32 percent, the shortfall should be made good by placing with SIDBI a deposit of an amount equivalent to the shortfall in each of the sub-targets. Also, in the event of failure on the part of banks to achieve one of the sub-targets or both the sub-targets, and also the overall target of 32 percent, the shortfall in achieving the sub-targets and the overall target should be made good by placing with SIDBI a deposit of an amount equivalent to

aggregate shortfall in the sub-targets, or the shortfall in the overall target, whichever shortfall is higher.

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In case the shortfall's in achievement of the overall target only and not in the sub-target, banks should make good the shortfall in achieving the overall target.The outstanding balances of these deposits placed with SIDBI may be reckoned as part of their priority sector advances during the currency of the deposits, as indirect finance to SSIs. The amount of deposits should, however, be shown separately in the returns on priority sector advances submitted to RBI.

Q7. What is CDR and how does it operate?

ANS)

Corporate Debt Restructuring

BackgroundIn spite of their best efforts and intentions, sometimes corporate find themselves in financial difficulty because of factors beyond their control and also due to certain internal reasons. For the revival of the corporate as well as for the safety of the money lent by the banks and FIs, timely support through restructuring in genuine cases is called for. However, delay in agreement amongst different lending institutions often comes in the way of such endeavours.

Based on the experience in other countries like the U.K., Thailand, Korea, etc. of putting in place institutional mechanism for restructuring of corporate debt and need for a similar mechanism in India, a Corporate Debt Restructuring System has been evolved, as under:

Objective

(i) The objective of the Corporate Debt Restructuring (CDR) framework is to ensure timely and transparent mechanism for restructuring of the corporate debts of viable entities facing problems, outside the purview of BIFR, DRT and other legal proceedings, for the benefit of all concerned. In particular, the framework will aim at preserving viable corporate that are affected by certain internal and external factors and minimize the losses to the creditors and other stakeholders through an orderly and coordinated restructuring programme.

Structure

(ii) CDR system in the country will have a three-tier structure:

CDR Standing ForumCDR Empowered GroupCDR Cell Corporate Debt Restructuring

(A) DR Standing Forum:

The CDR Standing Forum would be the representative general body of all financial institutions and banks participating in CDR system. All financial institutions and banks should participate in the system in their own interest. CDR Standing Forum will be a self-empowered body, which will lay down policies and guidelines, guide and monitor the progress of corporate debt restructuring.

The Forum will also provide an official platform for both the creditors and borrowers (by consultation) to amicably and collectively evolve policies and guidelines for working out debt restructuring plans in the interests of all concerned.

The CDR Standing Forum shall comprise Chairman & Managing Director, Industrial Development Bank of India; Managing Director, Industrial Credit & Investment Corporation of India Limited; Chairman, State Bank of India; Chairman, Indian Banks Association and Executive Director, Reserve Bank of India as well as Chairmen and Managing Directors of all banks and financial institutions participating as permanent members in

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the system. The Forum will elect its Chairman for a period of one year and the principle of rotation will be followed in the subsequent years. However, the Forum may decide to have a Working Chairman as a whole-time officer to guide and carry out the decisions of the CDR Standing Forum.

A CDR Core Group will be carved out of the CDR Standing Forum to assist the Standing Forum in convening the meetings and taking decisions relating to policy, on behalf of the Standing Forum. The Core Group will consist of Chief Executives of IDBI, ICICI, SBI, Bank of Baroda, Bank of India, Punjab National Bank, Indian Banks Association and a representative of Reserve Bank of India.

The CDR Standing Forum shall meet at least once every six months and would review and monitor the progress of corporate debt restructuring system. The Forum would also lay down the policies and guidelines to be followed by the CDR Empowered Group and CDR Cell for debt restructuring and would ensure their smooth functioning and adherence to the prescribed time schedules for debt restructuring. It can also review any individual decisions of the CDR Empowered Group and CDR Cell.

The CDR Standing Forum, the CDR Empowered Group and CDR Cell (described in following paragraphs) shall be housed in IDBI. All financial institutions and banks shall share the administrative and other costs. The sharing pattern shall be as determined by the Standing Forum.

(B) CDR Empowered Group and CDR Cell

The individual cases of corporate debt restructuring shall be decided by the CDR Empowered Group, consisting of ED level representatives of IDBI, ICICI Limited and SBI as standing members, in addition to ED level representatives of financial institutions and banks who have an exposure to the concerned company. In order to make the CDR Empowered Group effective and broad based and operate efficiently and smoothly, it would have to be ensured that each financial institution and bank, as participants of the CDR system, nominates a panel of two or three EDs, one of whom will participate in a specific meeting of the Empowered Group dealing with individual restructuring cases. Where, however, a bank / financial institution has only one Executive Director, the panel may consist of senior officials, duly authorized by its Board. The level of representation of banks/financial institutions on the CDR Empowered Group should be at a sufficiently senior level to ensure that concerned bank / Fl abides by the necessary commitments including sacrifices, made towards debt restructuring.

The Empowered Group will consider the preliminary report of all cases of requests of restructuring, submitted to it by the CDR Cell. After the Empowered Group decides that restructuring of the company is prima-facie feasible and the enterprise is potentially viable in terms of the policies and guidelines evolved by Standing Forum, the detailed restructuring package will be worked out by the CDR Cell in conjunction with the Lead Institution.

The CDR Empowered Group would be mandated to look into each case of debt restructuring, examine the viability and rehabilitation potential of the Company and approve the restructuring package within a specified time frame of 90 days, or at best 180 days of reference to the Empowered Group.

There should be a general authorization by the respective Boards of the participating institutions / banks in favour of their representatives on the CDR Empowered Group, authorizing them to take decisions on behalf of their organization, regarding restructuring of debts of individual corporate.

The decisions of the CDR Empowered Group shall be final and action-reference point. If restructuring of debt is found viable and feasible and accepted by the Empowered Group, the company would be put on the restructuring mode. If, however, restructuring is not found viable, the creditors would then be free to take necessary steps for immediate recovery of dues and/or liquidation or winding up of the company, collectively or individually.

(C) CDR Cell

A CDR Cell in all their functions will assist the CDR Standing Forum and the CDR EMPOWERED GROUP. The CDR Cell will make the initial scrutiny of the proposals received from borrowers / lenders, by calling for

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proposed rehabilitation plan and other information and put up the matter before the CDR Empowered Group, within one month to decide whether rehabilitation is prima facie feasible, if so, the CDR Cell will proceed to prepare detailed Rehabilitation Plan with the help of lenders and if necessary, experts to be engaged from outside. If not found prima facie feasible, the lenders may start action for recovery of their dues.

To begin with, CDR Cell will be constituted in IDBI, Mumbai and adequate members of staff for the Cell will be deputed from banks and financial institutions. The CDR Cell may also take outside professional help. The initial cost in operating the CDR mechanism including CDR Cell will be met by IDBI initially for one year and then from contribution from the financial institutions and banks in the Core Group at the rate of Rs.50 lakh each and contribution from other institutions and banks at the rate of Rs.5 lakh each.

All references for corporate debt restructuring by lenders or borrowers will be made to the CDR Cell. It shall be the responsibility of the lead institution / major stakeholder to the corporate, to work out a preliminary restructuring plan in consultation with other stakeholders and submit to the CDR Cell within one month. The CDR Cell will prepare the restructuring plan in terms of the general policies and guidelines approved by the CDR Standing Forum and place for the consideration of the Empowered Group within 30 days for decision. The Empowered Group can approve or suggest modifications, so, however, that a final decision must be taken within a total period of 90 days. However, for sufficient reasons the period can be extended maximum upto 180 days from the date of reference to the CDR Cell.

Other features:CDR will be a Non-statutory mechanismCDR mechanism will be a voluntary system based on debtor-creditor agreement and inter-creditor agreement.

The scheme will not apply to accounts involving only one financial institution or one bank. The CDR mechanism will cover only multiple banking accounts / syndication / consortium accounts with outstanding exposure of Rs.20 crore and above by banks and institutions.

The CDR system will be applicable only to standard and sub-standard accounts. However, as an interim measure, permission for corporate debt restructuring will be made available by RBI on the basis of specific recommendation of CDR "Core-Group", if a minimum of 75% (by value) of the lenders constituting banks and FIs consent for CDR, irrespective of differences in asset classification status in banks/financial institutions. There would be no requirement of the account / company being sick, NPA or being in default for a specified period before reference to the CDR Group. However, potentially viable cases of NPAs will get priority. This approach would provide the necessary flexibility and facilitate timely intervention for debt restructuring. Prescribing any milestone(s) may not be necessary, since the debt restructuring exercise is being triggered by banks and financial institutions or with their consent. In no case, the requests of any corporate indulging in willful default or misfeasance will be considered for restructuring under CDR.

Reference to Corporate Debt Restructuring System could be triggered by (i) any or more of the secured creditor who have minimum 20% share in either working capital or term finance, or (ii) by the concerned corporate, if supported by a bank or financial institution having stake as in (i) above.

Legal Basis

The Debtor-Creditor Agreement (DCA) and the Inter-Creditor Agreement shall provide the legal basis to the CDR mechanism. The debtors shall have to accede to the DCA, either at the time of original loan documentation (for future cases) or at the time of reference to Corporate Debt Restructuring Cell. Similarly, all participants in the CDR mechanism through their membership of the Standing Forum shall have to enter into a legally binding agreement, with necessary enforcement and penal clauses, to operate the system through laid-down policies and guidelines.

Stand-Still ClauseOne of the most important elements of Debtor-Creditor Agreement would be 'stand still' agreement binding for 90 days, or 180 days by both sides. Under this clause, both the debtor and creditor(s) shall agree to a legally binding 'stand-still' whereby both the parties commit themselves not to taking recourse to any other legal action

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during the 'stand-still' period, this would be necessary for enabling the CDR System to undertake the necessary debt restructuring exercise without any outside intervention judicial or otherwise.

The Inter-Creditors Agreement would be a legally binding agreement amongst the secured creditors, with necessary enforcement and penal clauses, wherein the creditors would commit themselves to abide by the various elements of CDR system. Further, the creditors shall agree that if 75% of secured creditors by value, agree to a debt-restructuring package, the same would be binding on the remaining secured creditors.

Accounting Treatment for Restructured Accounts

The accounting treatment of accounts restructured under CDR would be governed by the prudential norms indicated in circular DBOD. BP. BC. 98 / 21.04.048 / 2000-01 dated March 30,2001. Restructuring of corporate debts under CDR could take place in the following stages:

Before commencement of commercial production;

After commencement of commercial production but before the asset has been classified as sub-standard;

After commencement of commercial production and the asset has been classified as sub-standard.

The prudential treatment of the accounts, subjected to restructuring under CDR, would be governed by the following norms:

Treatment of standard accounts restructured under CDR

A rescheduling of the installments of principal alone, at any of the aforesaid first two stages [paragraph 5(a) and (b) above] would not cause a standard asset to be classified in the sub-standard category, provided the loan / credit facility is fully secured.

A rescheduling of interest element at any of the foregoing first two stages would not cause an asset to be downgraded to sub-standard category subject to the condition that the amount of sacrifice, if any, in the element of interest, measured in present value terms, is either written off or provision is made to the extent of the sacrifice involved. For the purpose, the future interest due as per the original loan agreement in respect of an account should be discounted to the present value at a rate appropriate to the risk category of the borrower (i.e. current PLR + the appropriate credit risk premium for the borrower-category) and compared with the present value of the dues expected to be received under the restructuring package, discounted on the same basis.

In case there is a sacrifice involved in the amount of interest in present value terms, as at (b) above, the amount of sacrifice should either be written off or provision made to the extent of the sacrifice involved.

Treatment of sub-standard accounts restructured under CDR

A rescheduling of the installments of principal alone, would render a sub-standard asset eligible to be continued in the sub-standard category for the specified period, provided the loan / credit facility is fully secured.

A rescheduling of interest element would render a sub-standard asset eligible to be continued to be classified in sub-standard category for the specified period subject to the condition that the amount of sacrifice, if any, in the element of interest, measured in present value terms, is either written off or provision is made to the extent of the sacrifice involved. For the purpose, the future interest due as per the original loan agreement in respect of an account should be discounted to the present value at a rate appropriate to the risk category of the borrower (i.e., current PLR + the appropriate credit risk premium for the borrower-category) and compared with the present value of the dues expected to be received under the restructuring package, discounted on the same basis.

In case there is a sacrifice involved in the amount of interest in present value terms, as at (b) above, the amount of sacrifice should either be written off or provision made to the extent of the sacrifice involved. Even in cases

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where the sacrifice is by way of write off of the past interest dues, the asset should continue to be treated as sub-standard.

The sub-standard accounts at (ii) (a), (b) and (c) above, which have been subjected to restructuring, etc. whether in respect of principal installment or interest amount, by whatever modality, would be eligible to be upgraded to the standard category only after the specified period, i.e., a period of one year after the date when first payment of interest or of principal, whichever is earlier, falls due, subject to satisfactory performance during the period. The amount of provision made earlier, net of the amount provided for the sacrifice in the interest amount in present value terms as aforesaid, could also be reversed after the one-year period.

During this one-year period, the sub-standard asset will not deteriorate in its classification if satisfactory performance of the account is demonstrated during the period. In case, however, the satisfactory performance during the one-year period is not evidenced, the asset classification of the restructured account would be governed as per the applicable prudential norms with reference to the pre-restructuring payment schedule.

The asset classification under CDR would continue to be bank-specific based on record of recovery of each bank, as per the existing prudential norms applicable to banks.

Q8. Identify the reasons for the growth of 'Non-Performing Advances' in the Banking Sector and suggest remedies for improving the quality of advances.

ANS)

Banking in India has its origin as early as the Vedic period. It is believed that the transition from money lending to banking must have occurred even before Manu, the great Hindu Jurist, who has devoted a section of his work to deposits and advances and laid down rules relating to rates of interest. During the Mogul period, the indigenous bankers played a very important role in lending money and financing foreign trade and commerce. During the days of the East India Company, it was the turn of the agency houses to carry on the banking business. The General Bank of India was the first Joint Stock Bank to be established in the year 1786. The others, which followed, were the Bank of Hindustan and the Bengal Bank. The Bank of Hindustan is reported to have continued till 1906 while the other two failed in the meantime.

In the first half of the 19th century the East India Company established three banks; the Bank of Bengal in 1809, the Bank of Bombay in 1840 and the Bank of Madras in 1843. These three banks also known as Presidency Banks were independent units and functioned well. These three banks were amalgamated in 1920 and a new bank, the Imperial Bank of India was established on 27th January 1921. With the passing of the State Bank of India Act in 1955 the undertaking of the Imperial Bank of India was taken over by the newly constituted State Bank of India.

The Reserve Bank which is the Central Bank was created in 1935 by passing Reserve Bank of India Act 1934. In the wake of the Swadeshi Movement, a number of banks with Indian management were established in the country namely, Punjab National Bank Ltd, Bank of India Ltd, Canara Bank Ltd, Indian Bank Ltd, the Bank of Baroda Ltd, the Central Bank of India Ltd. On July 19, 1969, 14 major banks of the country were nationalized and in 15th April 1980 six more commercial private sector banks were also taken over by the government. Today the commercial banking system in India may be distinguished into:

Public Sector Banksa. State Bank of India and its associate banks called the State Bank group b. 20 nationalized banks c. Regional Rural Banks mainly sponsored by Public Sector Banks

Private Sector Banks

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a. Old generation private banks b. New generation private banks c. Foreign banks in India d. Scheduled Co-operative Banks e. Non-scheduled Banks

CO-OPERATIVE SECTOR

The co-operative banking sector has been developed in the country to the supplement the village money lender. The co-operative banking sector in India is divided into 4 components

1. State Co-operative Banks 2. Central Co-operative Banks 3. Primary Agriculture Credit Societies 4. Land Development Banks 5. Urban Co-operative Banks 6. Primary Agricultural Development Banks 7. Primary Land Development Banks 8. State Land Development Banks

DEVELOPMENT BANKS

1. Industrial Finance Corporation of India (IFCI) 2. Industrial Development Bank of India (IDBI) 3. Industrial Credit and Investment Corporation of India (ICICI) 4. Industrial Investment Bank of India (IIBI) 5. Small Industries Development Bank of India (SIDBI) 6. SCICI Ltd. 7. National Bank for Agriculture and Rural Development (NABARD) 8. Export Import Bank of India 9. National Housing Bank

Q9. What are the different methods by which banks are required to classify their advances' portfolio?ANS)

Provisioning Norms GeneralIn order to narrow down the divergences and ensure adequate provisioning by banks, it was suggested that a bank's statutory auditors, if they so desire, could have a dialogue with RBI's Regional Office/ inspectors who carried out the bank's inspection during the previous year with regard to the accounts contributing to the difference.

Pursuant to this, regional offices were advised to forward a list of individual advances, where the variance in the provisioning requirements between the RBI and the bank is above certain cut off levels so that the bank and the statutory auditors take into account the assessment of the RBI while making provisions for loan loss, etc.

The primary responsibility for making adequate provisions for any diminution in the value of loan assets, investment or other assets is that of the bank managements and the statutory auditors. The assessment made by the inspecting officer of the RBI is furnished to the bank to assist the bank management and the statutory auditors in taking a decision in regard to making adequate and necessary provisions in terms of prudential guidelines.

In conformity with the prudential norms, provisions should be made on the non-performing assets on the basis of classification of assets into prescribed categories as detailed in paragraphs 4 supra. Taking into account the time lag between an account becoming doubtful of recovery, its recognition as such, the realisation of the

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security and the erosion over time in the value of security charged to the bank, the banks should make provision against sub-standard assets, doubtful assets and loss assets as below:

Loss assetsThe entire asset should be written off. If the assets are permitted to remain in the books for any reason, 100 percent of the outstanding should be provided for 100 percent of the extent to which the advance is not covered by the realizable value of the security to which the bank has a valid recourse and the realizable value is estimated on a realistic basis.In regard to the secured portion, provision may be made on the following basis, at the rates ranging from 20 percent to 50 percent of the secured portion depending upon the period for which the asset has remained doubtful:

Period for which the advance has been considered as doubtful

Provision requirement (%)

Up to one year 20

One to three years 30

More than three years 50

Floating provisionsSome of the banks make a 'floating provision' over and above the specific provisions made in respect of accounts identified as NPAs. The floating provisions, wherever available, could be set-off against provisions required to be made as per above stated provisioning guidelines. Considering that higher loan loss provisioning adds to the overall financial strength of the banks and the stability of the financial sector, banks are urged to voluntarily set apart provisions much above the minimum prudential levels as a desirable practice.

Provisions on Leased Assets

i) Sub-standard assets

10 percent of the 'net book value'.As per the 'Guidance Note on Accounting for Leases' issued by the ICAI, 'Gross book value' of a fixed asset is its historical cost or other amount substituted for historical cost in the books of account or financial statements. Statutory depreciation should be shown separately in the Profit & Loss Account. Accumulated depreciation should be deducted from the Gross Book Value of the leased asset in the balance sheet of the lesser to arrive at the 'net book value'.

Also, balance standing in 'Lease Adjustment Account' should be adjusted in the 'net book value' of the leased assets. The amount of adjustment in respect of each class of fixed assets may be shown either in the main balance sheet or in the Fixed Assets Schedule as a separate column in the section related to leased assets.

ii) Doubtful assets100 percent of the extent to which the finance is not secured by the realizable value of the leased asset. Realizable value to be estimated on a realistic basis. In addition to the above provision, the following provision on the net book value of the secured portion should be made, depending upon the period for which asset has been doubtful:

Period %age of provision

Up to one year 20

One to three years 30

More than three years 50

iii) Loss assets

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The entire asset should be written-off. If for any reason, an asset is allowed to remain in books, 100 percent of the 'net book value' should be provided for.

Guidelines for Provisions under Special CircumstancesGovernment guaranteed advances - With effect from 31 March 2000, in respect of advances sanctioned against State Government guarantee, if the guarantee is invoked and remains in default for more than two quarters (180 days at present), the banks should make normal provisions as prescribed in paragraph 4.1.2 above.As regards advances guaranteed by State Governments, in respect of which guarantee stood invoked as on 31.03.2000, necessary provision was allowed to be made, in a phased manner, during the financial years ending 31.03.2000 to 31.03.2003 with a minimum of 25 percent each year.

Advances granted under rehabilitation packages approved by BIFR/term lending institutions - In respect of advances under rehabilitation package approved by BIFR/ term lending institutions, the provision should continue to be made in respect of dues to the bank on the existing credit facilities as per their classification as sub-standard or doubtful asset.

As regards the additional facilities sanctioned as per package finalized by BIFR and/or term lending institutions, provision on additional facilities sanctioned need not be made for a period of one year from the date of disbursement.

In respect of additional credit facilities granted to SSI units which are identified as sick [as defined in paragraph 5(a) of RPCD circular No.PLNFS.BC.99/06.02.031/92-93 dated 17.04.93] and where rehabilitation packages/nursing programmes have been drawn by the banks themselves or under consortium arrangements, no provision need be made for a period of one year.

Advances against term deposits, NSCs eligible for surrender, IVPs, KVPs, and life policies are exempted from provisioning requirements.

However, advances against gold ornaments, government securities and all other kinds of securities are not exempted from provisioning requirements.

Treatment of interest suspense accountAmounts held in Interest Suspense Account should not be reckoned as part of provisions. Amounts lying in the Interest Suspense Account should be deducted from the relative advances and thereafter, provisioning as per the norms, should be made on the balances after such deduction.

Advances covered by ECGC/DICGC guaranteeIn the case of advances guaranteed by DICGC/ECGC, provision should be made only for the balance in excess of the amount guaranteed by these Corporations. Further, while arriving at the provision required to be made for doubtful assets, realizable value of the securities should first be deducted from the outstanding balance in respect of the amount guaranteed by these Corporations and then provision made as illustrated hereunder:

ExampleOutstanding Balance Rs. 4 lakhs

DICGC Cover 50 percent

Period for which the advance has regained doubtful More than 3 years remained doubtful

Value of security held (excludes worth of Rs.) Rs. 1.50 lakhs

Provision required to be madeOutstanding balance Rs. 4.00 lakhs

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Less: Value of security held Rs. 1.50 lakhs

Unrealised balance Rs. 2.50 lakhs

Less: DICGC Cover (50% of unrealisable balance) Rs. 1.25 lakhs

Net unsecured balance Rs. 1.25 lakhs

Provision for unsecured portion of advance unsecured portion) Rs. 1.25 lakhs (@ 100 percent o1

Provision for secured portion of advance secured portion) Rs. 0.75 lakhs (@ 50 percent o1

Total provision required to be made Rs. 2.00 lakhs

Advance covered by CGTSI guaranteeIn case the advance covered by CGTSI guarantee becomes non-performing, no provision need be made towards the guaranteed portion. The amount outstanding inr excess of the guaranteed portion should be provided for as per the extant guidelines on provisioning for non-performing advances. An illustrative examples are given below:

Asset classification status Doubtful - More than 3 years;

CGTSI Cover 75% of the amount outstanding or 75% of the unsecured amount or Rs.18.75 lakh, whichever is the least

Realisable value of Security Rs.1.50 lakhBalance outstanding Rs.10.00 lakhLess Realisable value of security Rs. 1.50 lakhUnsecured amount Rs. 8.50 lakhLess CGTSI cover (75%) Rs. 6.38 lakh

Net unsecured and uncovered portion: Rs. 2.12 lakh

Provision Required

Secured portion Rs.1.50 lakh Rs. 0.75 lakh (@ 50%)

Unsecured & uncovered portion Rs.2.12lakh Rs. 2.12 lakh (100%)Total provision required Rs. 2.87 lakh

Q10. NBFC mushroomed immediately after liberalization. There are very few left in the fray. Identify the reasons for their failure.

ANS)

Non-Bank Financial companies (NBFCs)

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A wide variety of NBFCs were accepting deposits from the public. Both financial and non-financial companies floated these NBFCs. Financial companies can be called as Non-Banking Financial Companies which accept deposits from the public and lend for commencement /development of business ventures and for rendering services etc. The other companies are basically manufacturing or trading companies and accept deposits from the public and finance their own sales/products either on hire purchase or lease basis.

The guidelines of RBI though applicable to NBFCs, the rate of interest offered on deposits and lending of NBFCs is market driven. However, of late with serious recession on the industrial front affecting the recoveries of NBFCs there have been defaults in repayment of deposits. This further slowed down the accretion to their deposit making the depositors to turn again to commercial banks. The NBFCs do call for stricter regulations to curb malpractices. Many of the NBFCs had to close shop due to high administrative cost, unplanned growth and rather no control on their operations. This prompted the RBI to devise stricter inspection methods and punish the unscrupulous elements, which were luring the public with the sop of high interest on deposits and had not maintained any financial discipline either in monitoring of advances or recovery.

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