1

A PROJECT REPORT ON

IMPACT OF BASEL & OTHER INDIAN COMMITTEES

RECOMMENDATIONS ON INDIAN BANKING SYSTEM

In partial fulfillment of the Dissertation

In Semester - IV of the Master of Business Administration

Prepared by:

Aayush Kumar

Registration No: 13010121218

Under the Guidance of

Prof. Shivaprasad.G

Bangalore

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Master of Business Administration

Declaration

This is to declare that the report entitled “IMPACT OF BASEL & OTHER INDIAN

COMMITTEES RECOMMENDATIONS ON INDIAN BANKING SYSTEM” is prepared

for the partial fulfillment of the Dissertation course in Semester IV of the Master

of Business Administration by me under the guidance of Prof. Shivaprasad.G.

I confirm that this dissertation truly represents my work. This work is not a

replication of work done previously by any other person. I also confirm that the

contents of the report and the views contained therein have been discussed and

deliberated with the Faculty Guide.

Signature of the Student :

Name of the Student : AAYUSH KUMAR

Registration No : 13010121218

3

Master of Business Administration

Certificate

This is to certify that Mr. Aayush Kumar Regn. No. 13010121218 has completed

the dissertation titled IMPACT OF BASEL & OTHER INDIAN COMMITTEES

RECOMMENDATIONS ON INDIAN BANKING SYSTEM under my guidance for the

partial fulfillment of the Dissertation course in Semester IV of the Master of

Business Administration

Signature of Faculty Guide:

Name of the Faculty Guide: Prof. SHIVAPRASAD. G

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CONTENTS

Chapter Page no.

Abstract

List of Tables

List of Charts

1. INTRODUCTION………………………………………………8-28

1.1 Statement of BASEL Norms

1.2 Introduction of Narasimham Committee

1.3 Introduction of Raghuram Rajan Committee

1.4 Introduction of Indian Banking System

2. RESEARCH METHODOLOGY……………………………...29-33

2.1 Need of the Study

2.2 Research Design and Survey Design

2.3 Data Analysis

2.4 Research Methodology

2.5 Research Design

2.6 Project Objectives

2.7 Expected Outcomes

3. DATA ANALYSIS……………………………………………...34-71

3.1 BASEL III

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3.2 Impact of BASEL III on Loan Spreads

3.3 Impact of BASEL III on Bank Capital

3.4 Narasimham Committee Recommendations and Action

3.5 Raghuram Rajan Committee Report Analysis

4. CONCLUSION & FINDINGS………………………………...72-84

4.1 BASEL III

4.2 Narasimham Committee

4.3 Raghuram Rajan Committee

5. REFERENCES…………………………………………………85-86

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LIST OF CHARTS/DIAGRAMS

SR NO PARTICULARS PG NO

1 Structure of Indian Banking 22

2 Core Banking Sector Indicators in India 24

3 Interest Rates in India 25

4 Capital to Risk Weighted Assets Ratio-Bank GroupWise 25

5 CRAR Levels of Indian Banking 35

6 CRAR Levels of Indian Banking 41

LIST OF TABLES

SR NO PARTICULARS PG NO

1 Comparison of Capital Requirement Standards 34

2 Deductions from Capital BASEL III guidelines Vs. Existing RBI

Norms

34-35

3 Sample Distribution by Category of Scheduled Commercial Banks

in India

38-39

4 Stylized Balance sheet and Income Statement of Scheduled

Commercial Banks

39

5 Levels of Capital Adequacy Ratios of Banks in selected Economies 40

6 Comparison of Capital Requirement Standards 41-42

7 Deductions from Capital BASEL III guidelines Vs. Existing RBI

Norms

42-43

8 Impact of Key Factors of Capital Standards on Equity 43-44

9 Possible Impact of Capital Standards on Indian Banks 44

10 BASEL III compliance – Required Minimum Capital 45

11 Comparison of Results for Estimations of Bank Loan Spread for

SCBs

71-72

12 Comparison of Results for Estimations of Bank Loan Spread for

SCBs

72

13 Increase in Bank Lending Spreads for a One Percentage Point

Increase in Bank Capital

72

14 Summary of Findings of Different Studies on Capital Requirement

of Indian Banks

73

15 Cost Benefit Analysis of BASEL III for Indian Banking 74

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ABSTRACT

The impacts of the global financial crisis coupled with domestic policy paralysis have dented

India’s growth prospects much more than what had been predicted. The implementation of

Basel III norms would considerably enhance the regulatory capital requirement of Indian

banks apart from subjecting them to rigorous regulatory monitoring. Undoubtedly, the

increased capital requirements would result in the increase in the cost to banks as well as to

borrowers. Given this context, this research project has adequately assessed the impact of the

new capital requirements introduced under the Basel III framework on bank lending rates

and loan growth and also estimated the extent of higher capital requirements for the Indian

banks.

This study has been successful in broadening and deepening the understanding of the

potential impact of Basel III framework along with other committee’s recommendations by

estimating the qualitative as well as quantitative impact of Basel III. This study observes that

new capital requirements under Basel III would have positive impact for Indian banks as they

raise the minimum core capital, introduce counter-cyclical measures, and enhance banks’

ability to conserve core capital in the event of stress through a conservation capital buffer. The

liquidity standard requirements would benefit the banks in managing the pressures on

liquidity in a stress scenario more effectively.

The study has estimated that the impact of Basel III on bank loan spreads would be 31 basis

points increase for every 1-percentage point increase in capital ratio and would go up to an

extent of 100 basis points for 6-percentage point increase in the capital ratio assuming that the

Risk weighted assets are unchanged. However, assuming the risk weighted assets to decline by

20 percent; the study finds that there would be 22 basis points increase for every 1-percentage

point increase in capital ratio and would go up to an extent of 68 basis points for 6-percentage

point increase in the capital ratio.

Estimating the additional capital requirements of Indian banks in the wake of Basel III

regime, this study estimates that with an assumed growth of RWAs at 10%, Indian banks

would require additional minimum tier-1 capital of INR 251106.57 Crores, and with RWAs

growth at 12% and 15%, the requirement is estimated to be respectively in the order of INR

336390.41 Crores and INR 474168.60 Crores.

It was one of the objectives of this study to make a cost-benefit analysis of the implementation

of Basel III in the Indian context. Accordingly, it is estimated that while the requirement of

additional minimum tier-1 capital would be INR 2,51,106 crores with RWAs assumed at 10%,

the probable prevention of loss-in-output due to a crisis (at a very conservative estimation)

would be in the range of INR 16,01,971 crores.

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CHAPTER 1

INTRODUCTION

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1.1 INTRODUCTION OF BASEL NORMS:

The Basel Banking Accords are norms issued by the Basel Committee on Banking Supervision

(BCBS), formed under the auspices of the Bank of International Settlements (BIS), located in

Basel, Switzerland. The committee formulates guidelines and makes recommendations on best

practices in the banking industry. The Basel Accords, which govern capital adequacy norms of

the banking sector, aim to ensure financial stability and thereby increase risk absorbing

capability of the banks.

The first set of Basel Accords, known as Basel I, was issued in 1988, with primary focus on

credit risk. It laid the foundation of risk weighting of assets and set objective targets of capital to

be maintained. Basel II was issued in 2004 with the objective of being more comprehensive. It

aimed at increasing capital adequacy by imposing a buffer for a larger spectrum of risk. As time

has gone by, we have witnessed the Basel norms failing to restrict two major crisis during its

tenure, the South Asian Crisis in 1998 and Sub-prime Mortgage Crisis in 2007, which raises

questions about its effectiveness. As the banking world prepares to comply with Basel III, the

effectiveness of the Basel accord has come under the radar.

The Committee seeks to achieve its aims by setting minimum supervisory standards; by

improving the effectiveness of techniques for supervising international banking business; and by

exchanging information on national supervisory arrangements. And, to engage with the

challenges presented by diversified financial conglomerates, the Committee also works with

other standard-setting bodies, including those of the securities and insurance industries.

The Committee's decisions have no legal force. Rather, the Committee formulates supervisory

standards and guidelines and recommends statements of best practice in the expectation that

individual national authorities will implement them. In this way, the Committee encourages

convergence towards common standards and monitors their implementation, but without

attempting detailed harmonization of member countries' supervisory approaches.

At the outset, one important aim of the Committee's work was to close gaps in international

supervisory coverage so that (i) no foreign banking establishment would escape supervision; and

(ii) that supervision would be adequate and consistent across member jurisdictions. A first step in

this direction was the paper issued in 1975 that came to be known as the "Concordat", which set

out principles by which supervisory responsibility should be shared for banks' foreign branches,

subsidiaries and joint ventures between host and parent (or home) supervisory authorities. In

May 1983, the Concordat was revised and re-issued as Principles for the supervision of banks'

foreign establishments .

In October 1996, the Committee released a report on The supervision of cross-border banking,

drawn up by a joint working group that included supervisors from non-G10 jurisdictions and

offshore centres. The document presented proposals for overcoming the impediments to effective

consolidated supervision of the cross-border operations of international banks. Subsequently

endorsed by supervisors from 140 countries, the report helped to forge relationships between

supervisors in home and host countries.

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Basel – I

Basel I Accord attempts to create a cushion against credit risk. It comprises of four pillars,

namely

Constituents of Capital: It prescribes the nature of capital that is eligible to be treated as

reserves.

Risk Weighting: Risk Weighting created a comprehensive system to provide weights to

different categories of bank’s assets (on balance sheet as well as off balance sheet assets)

on the basis of relative riskiness.

Target Standard Ratio: This acted as a unifying factor between the first two pillars. A

universal standard of 8% coverage of risk weighted assets by Tier I and II capital was set,

with at least 4% being covered by Tier I capital alone.

Transitional & implementing arrangements: Phase wise implementation deadlines were

set wherein a target of 7.25% was to be achieved by the end of 1990 and 8% by the end

of 1992.

Capital adequacy soon became the main focus of the Committee's activities. In the early 1980s,

the onset of the Latin American debt crisis heightened the Committee's concerns that the capital

ratios of the main international banks were deteriorating at a time of growing international risks.

Backed by the G10 Governors, the Committee members resolved to halt the erosion of capital

standards in their banking systems and to work towards greater convergence in the measurement

of capital adequacy. This resulted in a broad consensus on a weighted approach to the

measurement of risk, both on and off banks' balance sheets.

There was a strong recognition within the Committee of the overriding need for a multinational

accord to strengthen the stability of the international banking system and to remove a source of

competitive inequality arising from differences in national capital requirements. Following

comments on a consultative paper published in December 1987, a capital measurement system

commonly referred to as the Basel Capital Accord (or the 1988 Accord) was approved by the

G10 Governors and released to banks in July 1988.

The Accord called for a minimum capital ratio of capital to risk-weighted assets of 8% to be

implemented by the end of 1992. Ultimately, this framework was introduced not only in member

countries but also in virtually all other countries with active international banks. In September

1993, a statement was issued confirming that all the banks in the G10 countries with material

international banking business were meeting the minimum requirements set out in the 1988

Accord.

The 1988 capital framework was always intended to evolve over time. In November 1991, it was

amended to give greater precision to the definition of general provisions or general loan-loss

reserves that could be included in the capital adequacy calculation. In April 1995, the Committee

issued an amendment to the Capital Accord, to take effect at end-1995, to recognize the effects

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of bilateral netting of banks' credit exposures in derivative products and to expand the matrix of

add-on factors. In April 1996, another document was issued explaining how Committee members

intended to recognize the effects of multilateral netting.

The Committee also refined the framework to address risks other than credit risk, which was the

focus of the 1988 Accord. In January 1996, following two consultative processes, the Committee

issued the so-called Market Risk Amendment to the Capital Accord to take effect at the end of

1997 at the latest.

This was designed to incorporate within the Accord a capital requirement for the market risks

arising from banks' exposures to foreign exchange, traded debt securities, equities, commodities

and options. An important aspect of this amendment is that banks are allowed to use internal

value-at-risk models as a basis for measuring their market risk capital requirements, subject to

strict quantitative and qualitative standards. Much of the preparatory work for the market risk

package was undertaken jointly with securities regulators.

Basel – II

Basel II retained the ‘pillar’ framework of Basel I, yet crucially expanded the scope and specifics

of Basel I. The 4 pillars were amended as follows:

Minimum Capital Requirements, risks & target adequacy ratio: The primary mandate of

widening the scope of regulation was achieved by expanding the definition of banking

institutions to include them on a fully consolidated basis. Reserves requirement were

defined as follows:

Reserves = 8% * Risk-Weighted Assets + Operational Risk Reserves + Market Risk Reserves

Regulator-Bank Interaction: This empowers regulators in supervision and dissolution of

banks, giving them liberty to set buffer capital requirement above the minimum capital

requirement as per pillar I.

Banking Sector Discipline: It aims to induce discipline by mandating adequate

disclosures about capital and risk profile to the regulators and public.

The new framework was designed to improve the way regulatory capital requirements reflect

underlying risks and to better address the financial innovation that had occurred in recent years.

The changes aimed at rewarding and encouraging continued improvements in risk measurement

and control.

The framework's publication in June 2004 followed almost six years of intensive preparation.

During this period, the Basel Committee had consulted extensively with banking sector

representatives, supervisory agencies, and central banks and outside observers in an attempt to

develop significantly more risk-sensitive capital requirements.

Following the June 2004 release, which focused primarily on the banking book, the Committee

turned its attention to the trading book. In close cooperation with the International Organization

of Securities Commissions (IOSCO), the international body of securities regulators, the

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Committee published in July 2005 a consensus document governing the treatment of banks'

trading books under the new framework. For ease of reference, this new text was integrated with

the June 2004 text in a comprehensive document released in June 2006.

Both Committee member countries and several non-member countries agreed to adopt the new

rules, albeit on varying timescales. Thus, consistent implementation of the new framework

across borders has become a challenging task for the Committee. To encourage collaboration and

shared approaches, the Committee's Supervision and Implementation Group (SIG) serves as a

forum on implementation matters. The SIG discusses issues of mutual concern with supervisors

outside the Committee's membership through its contacts with regional associations. In January

2009, its mandate was broadened to concentrate on implementation of Basel Committee

guidance and standards more generally.

One challenge that supervisors worldwide faced under Basel II was the need to approve the use

of certain approaches to risk measurement in multiple jurisdictions. While this is not a new

concept for the supervisory community - the Market Risk Amendment of 1996 involved a similar

requirement - Basel II extended the scope of such approvals and demanded an even greater

degree of cooperation between home and host supervisors. To help address this issue, the

Committee issued guidance on information-sharing and supervisory cooperation and allocation

mechanisms in the context of Advanced Measurement Approaches in 2006 and 2007,

respectively.

Basel – III

There were several limitations of Basel II. It was recommended for G-10 counties, thus leaving

out the emerging economies. The scope of responsibilities for regulators in emerging economies

may be too much for them to handle. Central banks might not be stringent enough in regulating

private banks, thus letting them raise their risk exposure – defeating the entire purpose.

The essence of Basel III revolves around compliance regarding capital and liquidity. While good

quality of capital will ensure stable long term sustenance, compliance with liquidity covers will

increase ability to withstand short term economic and financial stress.

Liquidity Rules: The two standards of liquidity are:

Liquidity Coverage Ratio (LCR): This is to safeguard banks against sustained financial

stress for 30 days period.

Net Stable Funding Ratio (NSFR): The objective of long term stability of financial

liquidity risk profile is met by maintaining a ratio of amount available of stable funding

to required amount of stable funding at a minimum of 100%.

Capital Rules: Enhancement of risk coverage is achieved by introduction of Capital

Conservation Buffer and Countercyclical Buffer.

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Capital Conservation Buffer: A buffer of 2.5% (entirely out of Tier I capital) above

minimum capital requirement to be maintained to ensure that banks accumulate buffers in

time of low financial stress. It discourages distribution of earnings as a signal of financial

strength in times of reduced buffers

Countercyclical Buffer: This buffer can be enacted by national authorities when they

believe that the excess credit growth potentially implies a threat of financial distress.

Leverage Ratio: This aims to avoid the overuse of on- and off-balance sheet leverage in

the banking sector, despite portraying healthy risk based capital ratios, a characteristic of

the 2007 financial crisis.

Even before Lehman Brothers collapsed in September 2008, the need for a fundamental

strengthening of the Basel II framework had become apparent. The banking sector had entered

the crisis with too much leverage and inadequate liquidity buffers. These defects were

accompanied by poor governance and risk management, as well as inappropriate incentive

structures. The combination of these factors was manifest in the mispricing of credit and

liquidity risk, and excess credit growth.

Responding to these risk factors, the Basel Committee issued Principles for sound liquidity risk

management and supervision in the same month that Lehman Brothers failed. In July 2009, the

Committee issued a further package of documents to strengthen the Basel II capital framework,

notably with regard to the treatment of certain complex securitization positions, off-balance sheet

vehicles and trading book exposures. These enhancements were part of a broader effort to

strengthen the regulation and supervision of internationally active banks, in the light of

weaknesses revealed by the financial market crisis.

In September 2010, the Group of Governors and Heads of Supervision announced higher global

minimum capital standards for commercial banks. This followed an agreement reached in July

regarding the overall design of the capital and liquidity reform package, now referred to as

"Basel III". In November 2010, the new capital and liquidity standards were endorsed at the G20

Leaders Summit in Seoul. The Basel Committee has worked in close collaboration with the

Financial Stability Board (FSB) given the FSB's role in coordinating the monitoring of

implementation of regulatory reforms. The Committee designed its programme to be consistent

with the FSB's Coordination Framework for Monitoring the Implementation of Financial

Reforms (CFIM) as agreed by the G20.

These tightened definitions of capital, significantly higher minimum ratios and the introduction

of a macro prudential overlay represent a fundamental overhaul for banking regulation. At the

same time, the Basel Committee, its governing body and the G20 Leaders have emphasized that

the reforms will be introduced in a way that does not impede the recovery of the real economy.

In addition, time is needed to translate the new internationally agreed standards into national

legislation. To reflect these concerns, a set of transitional arrangements for the new standards

was announced as early as September 2010, although national authorities are free to impose

higher standards and shorten transition periods where appropriate.

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The new, strengthened definition of capital will be phased in over five years: the requirements

were introduced in 2013 and will be fully implemented by the end of 2017. Capital instruments

that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out

over 10 years beginning 1 January 2013.

Turning to the minimum capital requirements, the higher minimums for common equity and Tier

1 capital are being phased in from 2013, and will become effective at the beginning of 2015. The

schedule will be as follows:

The minimum common equity and Tier 1 requirements increased from 2% and 4% levels

to 3.5% and 4.5%, respectively, at the beginning of 2013.

The minimum common equity and Tier 1 requirements will be 4% and 5.5%,

respectively, starting in 2014.

The final requirements for common equity and Tier 1 capital will be 4.5% and 6%,

respectively, beginning in 2015.

The 2.5% capital conservation buffer, which will comprise common equity and is in addition to

the 4.5% minimum requirement, will be phased in progressively starting on 1 January 2016, and

will become fully effective by 1 January 2019.

The leverage ratio will also be phased in gradually. The test (the so-called "parallel run period")

began in 2013 and run until 2017, with a view to migrating to a Pillar 1 treatment on 1 January

2018 based on review and appropriate calibration.

The liquidity coverage ratio (LCR) will be phased in from 1 January 2015 and will require banks

to hold a buffer of high-quality liquid assets sufficient to deal with the cash outflows encountered

in an acute short-term stress scenario as specified by supervisors. To ensure that banks can

implement the LCR without disruption to their financing activities, the minimum LCR

requirement will begin at 60% in 2015, rising in equal annual steps of 10 percentage points to

reach 100% on 1 January 2019.

The other minimum liquidity standard introduced by Basel III is the net stable funding ratio. This

requirement, which will be introduced as a minimum standard by 1 January 2018, will address

funding mismatches and provide incentives for banks to use stable sources to fund their

activities.

Critical Review of BASEL III

The global financial meltdown in 2007-2009 bought to fore the limitations of the Basel II accord.

The norms failed to capture losses on off-balance sheet items leading to a decline in return on

equity, in spite of meeting capital adequacy ratios. The new Basel III accord intends to

proactively plug leakages from the previous norms.

For a country in crisis, it is estimated that, on an average, Basel III will impact by 4.9%, while

the estimates are substantially higher for non-crisis countries. Given the impact regulations on

capital adequacy can potentially have on a country, it is imperative for policy makers to

15

recognize reasons for high elasticity and high cost of equity. Further, it is prudent for the central

bank of a country to consider the capital adequacy norms and requirement of additional capital as

an important tool to regulate monetary policy.

Australia: Australia was largely insulated from the 2007 crisis. Two measures saved Australia in

this regard – the preventive actions taken prior to 2008, and the extraordinary public sector

intervention 2008 onwards.

The key preventive actions in the period prior to 2008 are as follows:

Well-managed Australian Authorized Deposit-taking Institutions (ADIs), which were

prudent to avoid taking on unsustainably risky assets;

Preemptive Australian Prudential Regulation Authority (APRA) supervision, maintaining

an emphasis on capital adequacy and sound asset quality; and

More stringent adoption of Basel II, which actually incorporated several propositions of

Basel III.

It is important to note that tough times could indeed arise as a consequence of economic

reversals in the Australian economy. In such a scenario, Australian ADIs would plausibly face a

far higher level of capital stress. Clearly, the Australian Basel II framework might prove to be

lacking. This is where the Basel III framework comes in – it incorporates a higher quality as well

as quantity of capital.

Brazil: Brazil is expected to implement Basel III norms by October 2013, and will follow the

international schedule as indicated by BCBS, with a few aspects to be implemented by 2012

itself. The requirement of additional capital to comply with Basel III norms is quite low in

Brazil, and hence, is unlikely to have a negative impact on economic growth. The grey line

indicates capital requirement of 11%. Except 3 banks, most of the banks comply with the

regulation. The capital adequacy shall be raised to 13% under Basel III norms, in which case, 9

banks shall have a shortfall, while 18 banks shall be uncomfortably close to the regulation.

However, banks shall have until 2019 to comply. Refer to Exhibit 4 for the timeline of phased

implementation of Basel III accord in Brazil.

United Kingdom: Across the EU, the Basel norms are implemented under the legal name of

Capital Requirements Directives (CRD). In UK, the responsibility of convergence to CRD is

equally shared between the Financial Services Authority (FSA) and the HM Treasury. Following

the 2008 financial turmoil gripping UK, the Prudential Regulation Authority (PRA) was formed

as a successor to Financial Services Authority (FSA), the banking regulator, in April 2013, as a

part of restructuring efforts for more effective supervision and governance. CRD IV, which

directs implementation of Basel III, has been approved by the EU parliament, with the

implementation to commence from January 2014. This creates an obligation to adopt the Basel

III norms on all the member countries including the United Kingdom.

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United States of America: Banking regulation is highly fragmented in U.S., because of the

existence of regulation at both the federal and state level. The U.S. has always been a laggard in

implementation of Basel norms. Multiple regulatory bodies have interest in the same issue.

All the banks in USA continue to follow the revised Basel I norms. Certain portions of advanced

approach of Basel II were implemented, which applies to the most complex banks. This led to

the Basel II norms being applicable for only large financial institutions, keeping the majority of

the banking community outside the purview.

The financial crisis of 2008 called for sweeping changes in banking supervision and regulation

standards in the country. Stringent capital requirements, severe credit analysis of securities rated

externally and enhancement of Pillar 2 (Supervisory and review process) and Pillar 3 (Disclose

and market discipline) were implemented.

Basel III shall be implemented in USA in a phased manner between January 1, 2013 and January

1, 2019. Implementation of Basel III norms in USA will require an additional Core Tier I Capital

to the extent of $700bn, and total Tier I capital of $870bn, with the gap in long term funding

estimated at $3.2trillion. These shortfalls are expected bring down Return on Equity of banks by

3%.

1.2 INTRODUCTION OF NARSIMHAM COMMITTEE:

From the 1991 India economic crisis to its status of third largest economy in the world by 2011,

India has grown significantly in terms of economic development. So has its banking sector.

During this period, recognizing the evolving needs of the sector, the Finance Ministry of

Government of India (GOI) set up various committees with the task of analyzing India's banking

sector and recommending legislation and regulations to make it more effective, competitive and

efficient. Two such expert Committees were set up under the chairmanship of M. Narasimham.

They submitted their recommendations in the 1990s in reports widely known as the Narasimham

Committee-I (1991) report and the Narasimham Committee-II (1998) Report. These

recommendations not only helped unleash the potential of banking in India, they are also

recognized as a factor towards minimizing the impact of global financial crisis starting in 2007.

Unlike the socialist-democratic era of the 1960s to 1980s, India is no longer insulated from the

global economy and yet its banks survived the 2008 financial crisis relatively unscathed, a feat

due in part to these Narasimham Committees.

During the decades of the 60s and the 70s, India nationalized most of its banks. This culminated

with the balance of payments crisis of the Indian economy where India had to airlift gold to

International Monetary Fund (IMF) to loan money to meet its financial obligations. This event

called into question the previous banking policies of India and triggered the era of economic

liberalization in India in 1991. Given that rigidities and weaknesses had made serious inroads

into the Indian banking system by the late 1980s, the Government of India (GOI), post-crisis,

took several steps to remodel the country's financial system. The banking sector, handling 80%

of the flow of money in the economy, needed serious reforms to make it internationally

reputable, accelerate the pace of reforms and develop it into a constructive usher of an efficient,

vibrant and competitive economy by adequately supporting the country's financial needs. In the

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light of these requirements, two expert Committees were set up in 1990s under the chairmanship

of M. Narasimham (an ex-RBI (Reserve Bank of India) governor) which are widely credited for

spearheading the financial sector reform in India. The first Narasimhan Committee (Committee

on the Financial System – CFS) was appointed by Manmohan Singh as India's Finance Minister

on 14 August 1991, and the second one (Committee on Banking Sector Reforms) was appointed

by P.Chidambaram as Finance Minister in December 1997. Subsequently, the first one widely

came to be known as the Narasimham Committee-I (1991) and the second one as Narasimham-II

Committee (1998). This article is about the recommendations of the Second Narasimham

Committee, the Committee on Banking Sector Reforms.

The purpose of the Narasimham-I Committee was to study all aspects relating to the structure,

organization, functions and procedures of the financial systems and to recommend improvements

in their efficiency and productivity. The Committee submitted its report to the Finance Minister

in November 1991 which was tabled in Parliament on 17 December 1991.

The Narasimham-II Committee was tasked with the progress review of the implementation of the

banking reforms since 1992 with the aim of further strengthening the financial institutions of

India. It focused on issues like size of banks and capital adequacy ratio among other things. M.

Narasimham, Chairman, submitted the report of the Committee on Banking Sector Reforms

(Committee-II) to the Finance Minister Yashwant Sinha in April 1998. The 1998 report of the

Committee to the GOI made the following major recommendations:

Autonomy in Banking - Greater autonomy was proposed for the public sector banks in order for

them to function with equivalent professionalism as their international counterparts. For this the

panel recommended that recruitment procedures, training and remuneration policies of public

sector banks be brought in line with the best-market-practices of professional bank management.

Secondly, the committee recommended GOI equity in nationalized banks be reduced to 33% for

increased autonomy. It also recommended the RBI relinquish its seats on the board of directors

of these banks. The committee further added that given that the government nominees to the

board of banks are often members of parliament, politicians, bureaucrats, etc., they often

interfere in the day-to-day operations of the bank in the form of the behest-lending. As such the

committee recommended a review of functions of banks boards with a view to make them

responsible for enhancing shareholder value through formulation of corporate strategy and

reduction of government equity. To implement this, criteria for autonomous status was identified

by March 1999 (among other implementation measures) and 17 banks were considered eligible

for autonomy. But some recommendations like reduction in Government's equity to 33%, the

issue of greater professionalism and independence of the board of directors of public sector

banks is still awaiting Government follow-through and implementation.

Reform in the role of RBI - First, the committee recommended that the RBI withdraw from the

91-day treasury bills market and that interbank call money and term money markets be restricted

to banks and primary dealers. Second, the Committee proposed a segregation of the roles of RBI

as a regulator of banks and owner of bank. It observed that "The Reserve Bank as a regulator of

the monetary system should not be the owner of a bank in view of a possible conflict of interest".

As such, it highlighted that RBI's role of effective supervision was not adequate and wanted it to

divest its holdings in banks and financial institutions. Pursuant to the recommendations, the RBI

18

introduced a Liquidity Adjustment Facility (LAF) operated through repo and reverse repos to set

a corridor for money market interest rates. To begin with, in April 1999, an Interim Liquidity

Adjustment Facility (ILAF) was introduced pending further up gradation in technology and

legal/procedural changes to facilitate electronic transfer. As for the second recommendation, the

RBI decided to transfer its respective shareholdings of public banks like State Bank of India

(SBI), National Housing Bank (NHB) and National Bank for Agriculture and Rural

Development (NABARD) to GOI. Subsequently, in 2007–08, GOI decided to acquire entire

stake of RBI in SBI, NHB and NABARD. Of these, the terms of sale for SBI were finalized in

2007–08 themselves.

Stronger banking system - The Committee recommended for merger of large Indian banks to

make them strong enough for supporting international trade. It recommended a three tier banking

structure in India through establishment of three large banks with international presence, eight to

ten national banks and a large number of regional and local banks. This proposal had been

severely criticized by the RBI employees union. The Committee recommended the use of

mergers to build the size and strength of operations for each bank. However, it cautioned that

large banks should merge only with banks of equivalent size and not with weaker banks, which

should be closed down if unable to revitalize themselves. Given the large percentage of non-

performing assets for weaker banks, some as high as 20% of their total assets, the concept of

"narrow banking" was proposed to assist in their rehabilitation. There were a string of mergers in

banks of India during the late 90s and early 2000s, encouraged strongly by the Government of

India GOI in line with the Committee's recommendations. However, the recommended degree of

consolidation is still awaiting sufficient government impetus.

Non-performing assets - Non-performing assets had been the single largest cause of irritation of

the banking sector of India. Earlier the Narasimham Committee-I had broadly concluded that the

main reason for the reduced profitability of the commercial banks in India was the priority sector

lending. The committee had highlighted that 'priority sector lending' was leading to the buildup

of non-performing assets of the banks and thus it recommended it to be phased out.

Subsequently, the Narasimham Committee-II also highlighted the need for 'zero' non-performing

assets for all Indian banks with International presence. The 1998 report further blamed poor

credit decisions, behest-lending and cyclical economic factors among other reasons for the

buildup of the non-performing assets of these banks to uncomfortably high levels. The

Committee recommended creation of Asset Reconstruction Funds or Asset Reconstruction

Companies to take over the bad debts of banks, allowing them to start on a clean-slate. The

option of recapitalization through budgetary provisions was ruled out. Overall the committee

wanted a proper system to identify and classify NPAs, NPAs to be brought down to 3% by 2002

and for an independent loan review mechanism for improved management of loan portfolios.

The committee's recommendations let to introduction of a new legislation which was

subsequently implemented as the Securitization and Reconstruction of Financial Assets and

Enforcement of Security Interest Act, 2002 and came into force with effect from 21 June 2002.

Capital adequacy and tightening of provisioning norms - To improve the inherent strength of

the Indian banking system the committee recommended that the Government should raise the

prescribed capital adequacy norms. This would also improve their risk taking ability; The

committee targeted raising the capital adequacy ratio to 9% by 2000 and 10% by 2002 and have

19

penal provisions for banks that fail to meet these requirements. For asset classification, the

Committee recommended a mandatory 1% in case of standard assets and for the accrual of

interest income to be done every 90 days instead of 180 days. To implement these

recommendations, the RBI in Oct 1998, initiated the second phase of financial sector reforms by

raising the banks' capital adequacy ratio by 1% and tightening the prudential norms for

provisioning and asset classification in a phased manner on the lines of the Narasimham

Committee-II report. The RBI targeted to bring the capital adequacy ratio to 9% by March 2001.

The mid-term Review of the Monetary and Credit Policy of RBI announced another series of

reforms, in line with the recommendations with the Committee, in October 1999.

Entry of foreign bank - The committee suggested that the foreign banks seeking to set up

business in India should have a minimum start-up capital of $25 million as against the existing

requirement of $10 million. It said that foreign banks can be allowed to set up subsidiaries and

joint ventures that should be treated on a par with private banks.

Critical Review of Narsimham Committee

There were protests by employee unions of banks in India against the report. The Union of RBI

employees made a strong protest against the Narasimham II Report. There were other plans by

the United Forum of Bank Unions (UFBU), representing about 1.3 million bank employees in

India, to meet in Delhi and to work out a plan of action in the wake of the Narasimham

Committee report on banking reforms. The committee was also criticized in some quarters as

"anti-poor". According to some, the committees failed to recommend measures for faster

alleviation of poverty in India by generating new employment. This caused some suffering to

small borrowers (both individuals and businesses in tiny, micro and small sectors).

In 1998, RBI Governor Bimal Jalan informed the banks that the RBI had a three to four-year

perspective on the implementation of the Committee's recommendations. Based on the other

recommendations of the committee, the concept of a universal bank was discussed by the RBI

and finally ICICI bank became the first universal bank of India. The RBI published an "Actions

Taken on the Recommendations" report on 31 October 2001 on its own website. Most of the

recommendations of the Committee have been acted upon (as discussed above) although some

major recommendations are still awaiting action from the Government of India.

Initially, the recommendations were well received in all quarters, including the Planning

Commission of India leading to successful implementation of most of its recommendations.

Then it turned out that during the 2008 economic crisis of major economies worldwide,

performance of Indian banking sector was far better than their international counterparts. This

was also credited to the successful implementation of the recommendations of the Narasimham

Committee-II with particular reference to the capital adequacy norms and the recapitalization of

the public sector banks. The impact of the two committees has been so significant that elite

politicians and financial sectors professionals have been discussing these reports for more than a

decade since their first submission applauding their positive contribution.

20

1.3 INTRODUCTION OF RAGHURAM RAJAN COMMITTEE REPORT:

India’s financial system holds one of the keys, if not the key, to the country’s future growth

trajectory. The financial system’s ability to efficiently intermediate domestic and foreign capital

into productive investment and to provide financial services to a vast majority of households will

influence economic as well as social stability.

While India’s financial institutions and regulatory structures have been developing gradually, the

time has come to push forward the next generation of financial reforms. The needs of a growing

and increasingly complex market-oriented economy, and its rising integration with global trade

and finance, call out for deeper, more efficient and well-regulated financial markets.

Notwithstanding concerns about its depth and efficiency, the financial system seems to have

enabled rapid growth and relatively moderate inflation. Arguably, it must be getting something

right. Why fix what ain’t broke? There are three main reasons. First, the financial system is

actually not working well in terms of providing adequate services to the majority of Indians,

meeting the large-scale and sophisticated needs of large Indian corporate, or penetrating deeply

enough to meet the needs of small and medium-sized enterprises. All of this will inevitably

become a barrier to high growth. Second, the financial sector—if unleashed but with proper

regulation--has the potential to generate millions of much-needed jobs and, more important, have

an enormous multiplier effect on economic growth and the inclusiveness of the financial system.

Third, in these uncertain times, financial stability is more important than ever to keep growth

from being derailed by shocks hitting the system, especially from abroad.

Even if one accepts all of this, why now? After all, the world’s deepest and most sophisticated

financial market seems to be imploding, and taking down many foreign financial institutions

with it. Perhaps it is time for India to batten down the hatches, insulate itself from global finance,

and not venture into sophisticated but apparently risky products. This is the wrong lesson to draw

from the U.S. sub-prime mess.

The right lesson is that markets and institutions do succumb occasionally to excesses, which is

why regulators have to be vigilant, constantly striking the right balance between attenuating risk-

taking and inhibiting growth. Similarly, the right lesson to be drawn from the Asian crisis is not

that foreign capital or financial markets are inherently destabilizing, but that weak legal

frameworks and toothless regulation, especially if coupled with public corruption and weak

corporate governance, can spell trouble. Financial sector reforms that lead to well-functioning

competitive markets can reduce these vulnerabilities. Indeed, the U.S. equity, government debt,

and corporate debt markets remain resilient, despite being close to the epicenter of the crisis.

But a robust financial system is not much good if most people don’t have access to it. Financial

inclusion, which means providing not just basic banking but also instruments to insure against

adverse events, is a key priority in India. The absence of access to formal banking services,

which affects more than one-third of poor households, leaves them vulnerable to informal

intermediaries such as moneylenders. Government-imposed priority-sector lending requirements

and interest rate ceilings for small loans have ended up restricting rather than improving broad

access to institutional finance. Banks have no incentive to expand lending if the price of small

loans is fixed by fiat. Consequently, nearly half of the loans taken by those in the bottom quarter

21

of the income distribution are from informal lenders at an interest rate above 36 percent a year,

well above the mandated lending rate. The solution is not more intervention but more

competition between formal and informal financial institutions and fewer strictures on the

former.

With so many difficult challenges, what is the way to proceed? One point to keep in mind is that

many of the reforms are intertwined. For instance, it makes sense to level the playing field

between banks and nonbank financial corporation’s by easing the requirement that the former

finance priority sectors and the government. But making these changes while the government

continues to have huge financing needs and without having a more uniform and nimble

regulatory regime could be dangerous.

The connections, which stretch beyond just financial reforms to broader macroeconomic

reforms, can in fact have a positive effect by reinforcing the effects of individual actions. For

instance, the process of removing restrictions on capital flows could serve as an adjunct to other

reforms if handled adroitly. Allowing foreign investors to participate more freely in corporate

and government debt markets could increase liquidity in those markets, provide financing for

infrastructure investment, and reduce public debt financing through banks.

India’s rich and complex political process being what it is, focusing solely on the big picture

could bog down progress. A hundred small steps, many of them less controversial but still

requiring some resolve on the part of policymakers, could get the process of reforms going and

build up momentum for the bigger challenges that lie ahead. For instance, converting trade

receivable claims to electronic format and creating a structure to allow them to be sold as

commercial paper could greatly boost the credit available to small and medium enterprises.

1.4 INDIAN BANKING SYSTEM:

For decades, banks in India have played an important role in shaping the financial system and

thereby contributing for economic development. This vital role of the banks in India continues

even today albeit the trends in banking delivery has undergone a sea change with the

advancement in usage of information technology as well as design and delivery of customer

service oriented products. Although there has been an extensive mention of existence of banking

in India even during the days of Rig Veda, the comparable banking understandable in terms of

modern banking can be traced to British rule in India during which agency houses carried on the

banking business. The first bank in India – The Hindustan Bank was established in 1779 and

later the General Bank of India was started in 1786. Three more banks namely, the Bank of

Bengal (1809), the Bank of Bombay (1840), and the Bank of Madras (1843) were formed and

were popularly known as “Presidency Banks”. Later in 1920, all the three presidency banks were

amalgamated to form the Imperial Bank of India on 27 January 1921.

The passing of the Reserve Bank of India Act in 1934 and the consequent formation of Reserve

Bank of India (RBI) in 1935 heralded a new era in the Indian banking evolution. Again, with the

passing of the State Bank of India Act in 1955, the undertaking of the Imperial Bank of India

was taken over by State Bank of India (SBI).

22

The Swadeshi movement gave a new dimension to the evolution of banking in India by giving a

fillip to the formation of joint stock banking companies like; The 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., etc. By 1941, there were around 41 Indian banking companies.

Post-Independence period in Indian banking witnessed the emergence of Reserve Bank of India

as India’s central banking authority after it was nationalized and taken over completely by the

Government of India. In 1949, the Banking Regulation Act was enacted which empowered the

Reserve Bank of India (RBI) “to regulate, control, and inspect the banks in India”. Further, the

Indian government decided to nationalize the banks as they failed to heed to the government

directions in enhancing credit to the priority sectors as directed by the government.

Consequently, 14 largest commercial banks nationalized on July 19, 1969. Further, a second

dose of nationalization of 6 more commercial banks followed in 1980. Nationalization of banks

witnessed a rapid expansion of bank branch network in India. Again in 1976, under the Regional

Rural Banks Act, several Regional Rural Banks (RRBs) were set up.

Structure of Indian Banking

India opened up its banking sector in 1991-92 as a part of globalization of Indian economy. The

financial sector reforms initiated by the government could bring in tectonic changes in the

structure and functioning of the commercial banks. Indian Banking structure is broadly made up of

Scheduled and unscheduled banks. Scheduled banks contribute to more than 95 percent of the

banking in India. Scheduled commercial banks include 26 public sector banks (State Bank of India

and its five associates, 19 nationalized banks and IDBI Bank Ltd.), 7 new private sector banks, 14

old private sector banks and 36 foreign banks. The number of SCBs increased to 83 in 2010-11

from 81 in 2009-10. The structure of Indian banking sector is presented in the figure

23

Source: Dr. Swamy “Basel III: Implication on Indian Banking”

As mentioned earlier, RRBs are also scheduled commercial banks with a specific focus and

agenda unlike the commercial banks whose operations are unlimited. RRBs are sponsored by

commercial banks along with the Central Government and the concerned State Governments. As

at the end of March 2011, there were, 82 RRBs functioning in the country (reduced from 196 in

early 2000s on account of restructuring and amalgamation of existing RRBs to improve their

financial soundness). By the end of March 2011, while the assets of RRBs stood at INR 2,15,359

crores (a growth of 17% over the previous year), the deposits were at a level of INR 1,66,232

crores (a 14.6% growth over the previous year). Further, while the advances of RRBs stood at

INR 94,715 crores (a 19.7% growth over previous year), the investments were to the tune of INR

55,280 crores (a growth of 16.9% over the previous year) by the end of March 2011.

There were 97410 cooperatives in the country as at the end of March 2011 amongst which the

Urban Cooperative Banks (UCBs) were 1645 and rural cooperatives were 95765. Amongst the

UCBs only 53 were scheduled and the remaining 1592 were unscheduled ones. In addition,

amongst the rural cooperatives, long-term cooperatives constituted 717 and the short-term

cooperatives were 95048. While the cooperative banks have a long history of their own, due to

various reasons such as; Lack of recognition of cooperatives as economic institutions, structural

diversity across states, design issues, board and management interface and accountability and

24

politicization of cooperatives and control/interference by government, etc., they have been

constrained in attaining their expected performance.

Development Banks are generally termed as all India financial institutions. As at end-March

2011, there were five financial institutions (FIs) under the regulation of the Reserve Bank viz.,

EXIM Bank, NABARD, NHB, SIDBI and IIBI. Of these, four FIs (EXIM Bank, NABARD,

NHB and SIDBI) are under full-fledged regulation and supervision of the Reserve Bank of India.

Operations and Performances of Indian Banking

The Indian banking sector regarded as edifice of the Indian financial sector, though weathered

the stressful consequences of the global financial instability largely, had to traverse through a

challenging macro-economic environment during the post-crisis period. Shadowed by the

financial crisis, the global financial sector was generally turbulent mainly because of the

European sovereign debt crisis, and sluggish growth recovery in the Euro zone as also in the US.

According to RBI (RBI 2011, p 59), the Indian banking sector performed better in 2010-11 over

the previous year despite the challenging operational environment.

The business of SCBs recorded higher growth in 2010- 11 as compared with their performance

during the last few years. Credit deployment has grown at 22.9 per cent and deposits have grown

at 18.3 per cent in 2010- 11 over the previous year. Consequently, the outstanding credit-deposit

ratio of SCBs has increased to 76.5 per cent in 2010-11 as against 73.6 per cent in the previous

year. While the assets of the SCBs stood at INR 71, 83,522 crores, the deposits were to the tune

of INR 56, 16,432 crores and advances outstanding were INR 42, 98,704 crores. Further

investments of SCBs stood at INR 19, 16,053 crores. Indian financial sector’s resilience lies in

the fact that around 70% of it is domestically owned. In addition, about 74% of the assets of the

Indian banking sector are held by the public sector banks. The relatively feeble presence of

foreign banks helped the sector minimize its exposure to the global toxic assets and thereby had a

minimal impact of the devastative global financial crisis. The off-balance sheet exposures of the

Indian banking sector, which declined during the crisis years 2008-09, 2009-10, have witnessed a

growth of 31 per cent in 2010-11. More than 75% of off-balance sheet exposures in 2010-11

constituted forward exchange contracts. Further, the share of foreign banks constituted more than

66% of off-balance sheet exposures during 2010- 11. Despite the growing pressures on margins owing to higher interest rate environment, the return

on assets (ROA) of SCBs improved to 1.10 per cent in 2010-11 from 1.05 per cent in 2009-10.

The capital to risk weighted assets ratio under both Basel I and II frameworks stood at 13.0 per

cent and 14.2 per cent, respectively in 2010-11 as against the required minimum of 9 per cent.

The gross Non-Performing Assets (NPAs) to gross advances ratio declined to 2.25 per cent in

2010-11 from 2.39 per cent in 2009-10, displaying improvement in asset quality of the banking

sector. Although there was some advancement in the penetration of banking services in 2010-11

over the previous year, the extent of financial exclusion continued to be swaging.

Banking sector being an integral part of the economy in ensuring the efficient transmission of the

funds, it has a close relationship with the other macro-economic factors that play a vital part in

the economic development. Despite the downward movement of some of the economic

25

indicators like the imports and exports, the bank credit has continued to show rising trend in

view of the strong domestic demand led growth.

Financial Soundness in Indian Banking

Banking sector is by far the most central part of the financial system in most of the emerging

economies and is, therefore, also the main source of risk for financial stability. Undoubtedly,

financial soundness of banks has a significant sway on the stability of the financial system as a

whole as the banking system constitutes more than 75% of the financial markets in India. The

Indian banking system endured the onslaught of the global financial crisis and a factor that

bolstered the normal functioning of the banking system even in the face of one of the largest

global financial crisis was its robust capital adequacy. Further, the core banking sector indicators

for India like; Capital Adequacy Ratio (CAR), Capital Adequacy Ratio–Tier-1, Gross Non-

Performing Assets (GNPAs) to total loans, Net Non- Performing Assets (NNPAs) to total loans

and Return on Equity (ROE) have experienced downward pressure during the recent recession

period.. On the contrary, liquid assets to total assets ratio has moved upwards indicating the

tendency of the banks to hold cash during the times of recession instead of investing in loans or

investment products.

Core Banking Sector Indicators in India

Source: Dr. Swamy “Basel III: Implication on Indian Banking”

Interest Rates (Benchmark prime lending rate), Money market rate and the discount rates) which

have significant impact on the lending activity showed downward movement in the Indian

banking scenario

26

Interest Rates in India

Source: Dr. Swamy “Basel III: Implication on Indian Banking”

Under Basel II, Capital to Risk-weighted Assets Ratio (CRAR) of Indian banks as at end-March

2009 was at 14.0 per cent, far above the stipulated level of 9 percent (Figure-5.6). This suggests

that Indian banks have successfully managed to meet the increased capital requirement under the

amended framework.

Capital to Risk Weighted Assets Ratio–Bank Group-wise (As at end-March)

Source: Dr. Swamy “Basel III: Implication on Indian Banking”

27

Prudential Regulation in Indian Banking

Prudential regulation mostly characterizes the adoption of best practices as stipulated by Basel

Accord. However, in devising the regulatory framework for banks, RBI has always kept in focus

the financial stability objective. Some of the counter-cyclical regulatory measures that are now

attracting attention worldwide were already in place in India even before the looming of the

crisis

In terms of capital requirements, even though, as per Basel norms the minimum capital adequacy

ratio (CAR) for banks is 8%, the Indian banks are asked by RBI to maintain the ratio at 9%.

Further, the banks are also stipulated to ensure a minimum Tier I capital ratio of 6 % from April

1, 2010. The current average CAR for the SCBs in India is over 13% while the Tier I capital

ratio is about nine percent. Further, Tier I capital is stated as the one that does not include items

such as intangible assets and deferred tax assets that are now sought to be deducted

internationally.

In the terms of liquidity buffers, Indian banks are found to have substantial holding of liquid

assets as they are required to maintain cash reserve ratio (CRR) which is currently 4.75% and

statutory liquidity ratio (SLR) currently 24% - both ratios as a proportion to their ‘net liabilities’.

As such, in case of maintenance of excess of SLR requirements is always available as a source of

liquidity buffer. Moreover, in order to mitigate liquidity risks at short end, RBI had already

issued detailed Asset-Liability Management (ALM) guidelines encompassing liquidity risk

measurement, reporting framework and prudential limits.

In terms of managing the leverage by banks, RBI has been keeping a watch through the

prudential focus on credit-deposit ratio (CD ratio or CDR) and SLR. Moreover, a prudent focus

on CDR encourages the banks to raise deposits for funding credit flow thus minimizing the use

of purchased funds. Further, as the requirement for SLR is to hold unencumbered securities,

banks cannot leverage the minimum SLR portfolio to take on more assets. Accordingly, the

focus on credit deposit ratio and the SLR prescription have both served to limit the degree of

leverage in the Indian banking system.

Securitization of assets by Indian banks has been regulated by RBI under its guidelines issued in

February 2006. Accordingly, the banks (originators) are prohibited from booking profits upfront

at the time of securitization and also the release of credit enhancement during the life of the

credit-enhanced transaction is disallowed. In view of the same, banks were not having any

incentives to resort to unbridled securitization as observed in “originate-to-distribute57” and

“acquire and arbitrage”58 models of securitization as found in many other countries.

In order to contain the short-term liquidity crisis, RBI recognized the possible impact of

excessive inter- connectedness within the banking system, and has stipulated a restriction on

inter-bank liabilities (IBL) to twice the bank’s net worth. In addition, a higher limit up to 3 times

the net worth is allowed only for those banks whose CAR is at least 25% more than the

minimum of 9%. With a view to recognize the impact that restructuring of credit and slower

growth of credit could have on the credit quality of the banks and also considering the necessity

28

to build up provisions when the bank’s earnings are good, RBI has, in December 2009 advised

the banks to maintain a provision coverage ratio of not below 70% by September 2010.

29

CHAPTER 2

RESEARCH

METHODOLOGY

30

2.1 NEED OF THE STUDY:

The topic undertaken for the dissertation is “Impact of BASEL and Other Indian Committees

Recommendation on Indian Banking System”. The purpose behind opting this topic is immense

potential of the Indian banking sector. Half of the population still lives in the villages, which

needs to be included in the financial system for the inclusive growth of the economy and reduce

the NPAs.

In order to improve the banking sector, various committees have been formed such as

Narasimham committee, Raghuram Rajan committee etc for Indian banks. Similarly BASEL

committee had been formed in order to improve the banking sector worldwide by G10 countries.

As it is the era of globalization and liberalization, most of the economies have been linked with

each other. Anything happened in one country has cascading effect on the other countries’

economy. The effect was recently observed in the 2008 market crash and defaulting of various

European countries on their debt obligation (PIGS countries). Any crash or boom has one thing

in common and that plays a key role in order to make it happen. It is the money flow mechanism

of the countries’ banking sector liquidity. A fragile banking industry could not sustain the growth

of the economy for a longer period of time. This can be clearly proved by 2008 crisis, which

leads to the fall of many banking giants which were too large to fall.

2.2 RESEARCH DESIGN AND SURVEY DESIGN:

Research approach would be based on the quantitative & qualitative section. Here, the data and

information gathered would be in moreover in the form of text, comments or numeric value. We

have to screen all the collected data and information and scratch out the required information out

of that. Here, we have to rely on the information, comments or data released/provided by the

designated authorities related to the RBI. The data would be gathered and distributed in form of

text and numeric only and put at the required stages.

Accordingly considered research approaches is essential, as it permits researcher to draw more

conversant information about the selected research design; this information afterward permits the

researcher to acclimatize the research design and furnish for limitations (Easterby- Smith et al

2002) cited by Saunders (2007).

2.3 DATA ANALYSIS:

The Data would be analyzed from the texts, numeric information provided by the experts and

samples. This information would be segregated as per the requirement and the concrete

information will be distributed according to the required heads.

(A) Secondary Data – The data would be collected from the earlier Journals, and data

collected from the designated authorities

The data would be moreover in the form of numeric value of text information, so that has to be

converted into presentable or graphical form as per the requirement of the project.

31

2.4 RESEARCH METHODOLOGY:

(A) Historical research

It creates explanations & sometimes attempted explanations, of conditions, situations and events

that have occurred in near past. For Example, Any research that documents the evolution of

teacher training program since the turn of century, with the focus of defining the historical

origins of the content and processes of current programs (Postlethwaite, 2005)

Here, in this study, this methodology may solve the problem because, the study on Impact of

BASEL and other Indian Committees Recommendations on Indian Banking System.

(B) Descriptive research

It provides information about conditions, situations and events that occur in the current. For

example, a survey of the physical conditions of school building in order to establish a descriptive

profile of the facilities that exist in a typical school. (Postlethwaite, 2005)

This is a very elaborative and correct kind of research method, where we not only rely on the

past trends and studies but also can observe the current studies and current concepts. The study

on study on Impact of BASEL and other Indian Committees Recommendations on Indian

Banking System

(C) Correlation research

It involves the search for relationship between variables through the use of various measures of

statistical association. For example, an investigation of the relationship between teachers’

satisfaction with their job and various factors describing the provision and quality of teacher

housing, salaries, leave entitlements, and the availability of class room supplies. (Postlethwaite,

2005)

Correlation research method makes relationship between two variables. And our study does not

satisfy this methodology because we are studying on only study on Impact of BASEL and other

Indian Committees Recommendations on Indian Banking System. The sector selected is only

RBI Guidelines, i.e., if there would be comparison between two industries then it could be used.

(D) Causal research

It aims to suggest casual linkages between variables by observing existing phenomena and then

searching back through available data in order to try to identify plausible casual relationships.

For example, a study of factors related to student ‘drop out’ from secondary school using data

obtained from school records over the past decade. (Postlethwaite, 2005)

Our study regarding “Impact of BASEL and other Indian Committees Recommendations on

Indian Banking System” does not satisfy this kind of research methodology because, this study is

completely depended on the factual data and theories, and casual method simply solves the

problems which have been already almost solved. It means, this method is suitable when you

already know the results but you simply need any fact to support that.

32

(E) Experimental research

It is used in settings where variables defining one or more “causes” can be manipulated in a

systematic fashion in order to discern “effects’ on other variables. For Example, an investigation

of the effectiveness of two new textbooks using random assignment of teachers and students of

three groups – two groups for each of the new textbooks, and one group as a ‘control’ group to

use the existing textbook. (Postlethwaite, 2005)

Experimental research methodology is suitable where we are completely studying any field or

study which is altogether virgin and has not been touched earlier. And the researcher has to make

various experiments to come out on one result. Here, we are studying a field where, we are

moreover relied on the persons and information which is already existed in this field.

(F) Case study research

It generally refers to two distinct research approaches. The first consist of and in depth of a

particular student, classroom or school with the aim of producing a nuanced description of

pervading cultural setting that affects education, and an account of the interactions that take

place between students and other relevant persons. For example, an in-depth exploration of the

patterns of friendship between students in a single class, the second approach to case study

research involves the application of quantitative research methods to non-probability samples-

which provide results that are not necessarily designed to generalizable to wider populations. For

example, a survey of the reading achievements of the students in one rural region of a particular

country (Postlethwaite, 2005)

Case study research more over focus on the past data and past information, where we study a

case, which is almost similar to our current problem or study so, as such we are not dealing with

such kind of study or case, we are collecting desecrated information from different places and

gathering at one common place to come out on one judgment.

(G) Ethnographic research

It usually consists of a description of events that occur within the life of a group – with particular

reference to the interaction of individuals in the context of socio cultural norms, rituals and

beliefs shared by the group. The researcher generally participates in some part of the normal life

of the group and uses what he or she learns from his participation to understand the interactions

between group members. For example, a detailed account of the daily tasks and interactions

encountered by a school principal using observations gathered by a researcher who is placed in

the position of “Principal’s Assistant’ in order to become fully involved in the daily life of the

school. (Postlethwaite, 2005)

This type of method suffices the kind the research which is not based on data and facts but on the

social and cultural behavior of the people, for example to understand the customers purchasing

behavior etc. So, our study does not suit this method.

(H) Research and development research

It differs from the above types of research in that, rather than bringing new information to light,

it focuses on the interaction between research and the production and evaluation of a new

product. This type of research can be ‘formative’. For example, an investigation of teachers’

33

reactions to the various drafts and redrafts of a new mathematics teaching kit, with the

information gathered at each stage being used to improve each stage of the drafting process.

Alternatively, it can be used summative. For example, a comparison of the mathematics

achievements of student exposed to anew mathematics teaching kit in comparison with students

exposed to the established mathematics curriculum. (Postlethwaite, 2005)

Well, this kind of method itself defines that it is not suitable for our study, which we are doing

on “Impact of BASEL and other Indian Committees Recommendations on Indian Banking

System”.

So, finally, from all the above mentioned research methodology, we reached on the point that,

the current study “Impact of BASEL and other Indian Committees Recommendations on Indian

Banking System” satisfy the Descriptive research method. Because, here we are suppose to deal

with the information and data which is based on the past facts and figures and at the same

moment current judgment and studies.

2.5 RESEARCH DESIGN:

Phase I- Exploratory work

Exploratory information has been collected from the interviews (mentioned in various journals)

of the various senior officials related BASEL & Other committee recommendations in RBI

Journals.

Phase II- Descriptive research

Descriptive study is done from the various journals, websites & from the books of the authors,

who have specifically written about the BASEL & Other committee's recommendations.

Research Type: Descriptive.

2.6 PROJECT OBJECTIVE:

Research on the recommendation of BASEL committees.

Research on the recommendation of Indian banking committees such as Narasimham

committee, Raghuram Rajan committee etc.

Before and after the implementation of these recommendation in the banking industry.

Analysis of the bank’s balance sheet for the improvements after the recommendation.

2.7 EXPECTED OUTCOME:

Better understanding of the banking industry regulation.

Banking structure in India.

Regulatory structure of the banks in Indian and global.

Impact of the committee’s recommendation on Indian banking sector.

Various risks faced by the banks.

Day to day capital requirements by the banks for their smooth operation

34

CHAPTER 3

DATA ANALYSIS

35

3.1 BASEL III:

Basel III guidelines attempt to enhance the ability of banks to withstand periods of economic and

financial stress by prescribing more stringent capital and liquidity requirements for them. The

new Basel III capital requirement would be a positive impact for banks as it raises the minimum

core capital stipulation, introduces counter-cyclical measures, and enhances banks’ ability to

conserve core capital in the event of stress through a conservation capital buffer. The prescribed

liquidity requirements, on the other hand, would bring in uniformity in the liquidity standards

followed by the banks globally. This liquidity standard requirement, would benefit the Indian

banks manage pressure on liquidity in a stress scenario more effectively. Although implementing

Basel III will only be an evolutionary step, the impact of Basel III on the banking sector cannot

be underestimated, as it will drive significant challenges that need to be understood and

addressed. Working out the most cost-effective model for implementation of Basel III will be a

critical issue for Indian banking.

Impact on Financial System - Basel III framework implementation would lead to reduced risk of

systemic banking crises as the enhanced capital and liquidity buffers together lead to better

management of probable risks emanating due to counterparty defaults and or liquidity stress

circumstances. Further, in view of the stricter norms on Inter-bank liability limits, there would be

reduction of the interdependence of the banks and thereby reduced interconnectivity among the

banks would save the banks from contagion risk during the times of crises.

Undoubtedly, Basel III implementation would strengthen the Indian banking sector’s ability to

absorb shocks arising from financial and economic stress, whatever the source be, and

consequently reduce the risk of spillovers from the financial sector to the real economy.

On Weaker Banks- Further, there would be a drastic impact on the weaker banks leading to their

crowding out. As is well established, as conditions deteriorate and the regulatory position gets

even more intensive, the weaker banks would definitely find it very challenging to raise the

required capital and funding. In turn, this would affect their business models apart from tilting

the banking businesses in favor of large financial institutions and thereby tilting the competition.

Increase Supervisory Vigil - Banking operations might experience a reduced pace as there

would be an increased supervisory vigil on the activities of the banks in terms of ensuring the

capital standards, liquidity ratios – LCR and NSFR and others.

Reorganization of Institutions - The increased focus of the regulatory authorities on the

organizational structure and capital structure ability of the financial firms (mainly banks) would

lead the banks to reorganize their legal identity by resorting to mergers & acquisitions and

disposals of portfolios, entities, or parts of entities wherever possible.

International Arbitrage - In case of inconsistent implementation of Basel III framework among

different countries would lead to international arbitrage thereby resulting in disruption of global

financial stability.

36

Capital standards for India - Indian banks need to look for quality capital and also have to

preserve the core capital as well as use it more efficiently in the backdrop of Basel III

implementation. Indian banks look comfortably placed; they will have to phase out those

instruments from their capital that are disallowed under Basel III.

Comparison of Capital Requirement Standards

Minimum Capital Ratios Basel

III of

BCBs

Basel III

of RBI

Existing

RBI

norms

PSBs

Current

Position

Private

Banks

Current

Position

Minimum Common Equity Tier 1

(CET1)

4.5% 5.5% 3.6% 7.3% 11.2%

Capital Conservation Buffer

(CCB)

2.5% 2.5% - - -

Minimum CET1 + CCB 7% 8% 3.5% 7.3% 11.2%

Minimum Tier 1 Capital 7% 7% 3.6% 7.3% 11.2%

Minimum Total Capital Including

Buffer

8% 9% 6% 8.1% 11.5%

Minimum Total Capital + CCB 10.5% 11.5% 9.0% 12.1% 15.9%

Additional Counter Cyclical

Buffer in the form of Common

Equity Capital

0-

2.5%

0-2.5% NA NA NA

Source: RBI Guidelines

Deductions from Capital – Basel III guidelines Vs. Existing RBI norms

Particulars BASEL III of RBI Existing RBI Norms Impact

Limit on deductions

Deductions would be

made if deductibles

exceed the 15% of

core capital at an

aggregate level, or

10% at the individual

item level.

All deductibles to be

deducted

Positive

Deductions from Tier

I or Tier II

All deductions from

core capital

50% of the deductions

from Tier I and

remaining 50% from

Tier II capital

(excepting DTAs and

intangibles where

100% deduction is

made from Tier I

capital

Negative

Treatment of

significant

Aggregated total

equity investment in

For investments upto:

(a) 30%:

Negative

37

investments in

common shares of

unconsolidated

financial

entities

entities where banks

own more than 10%

of shares • (a) Less

than 10% of banks’

common equity – 250

risk

weight (b) More than

10 % will

be deducted from

common

equity

125% risk weight or

risk weight as

warranted by external

rating

(b) 30-50%: 50%

deduction from Tier I

capital and 50% from

Tier II capital

Source: RBI Guidelines

Out of 10.50%, total equity, the capital (equity + reserves) requirement is hiked from the existing

2% to 7%. However, tier II capital that is hybrid capital (fund raising through mostly debt

instruments) dumped from 4% to 2%. Further, with the stipulation of “countercyclical buffer” of

up to 2.5%, the total CAR requirement would raise upto 13%.

Though Indian banks are undoubtedly well capitalized, and maintaining a higher equity capital

ratio than stipulated under Basel III guidelines, they are indeed required to strengthen their

common equity after the relevant deductions. Investor preference would require the banks to

ensure that all the banks would have to maintain an equity capital ratio of higher than 7% by

2013.

CRAR Levels of Indian Banking

Source: Developed by author based on data from RBI Publications

In view of the predicted favorable economic growth over the next three years, it would enable

the banks to shore up their capital bases through issuance of equity. However, a few of the below

38

average performing banks may be necessitated to raise additional equity capital to maintain the

required 7%.

3.2 IMPACT OF BASEL III ON LOAN SPREADS:

The purpose of this section is to map the capital and liquidity requirements as per Basel III to

bank lending spreads. This estimation supposes that the return on equity (ROE) and the cost of

debt are unaffected, with no change in other sources of income and on the same line of thought it

is further assumed that there is no reduction in operating expenses. Such a mapping endows

researchers with a useful instrument to analyze the impact of regulatory changes on the cost of

credit and the real economy. A raise in the interest rate charged on bank loans is believed to

reduce loan demand, all else equal, leading to a drop in investment and output.

This methodology has been employed in the BCBS’s assessment of the long-term economic

impact of the proposed regulatory changes on output (BCBS, 2010, King, 2010). Further, the

benefit of these estimates of changes in bank lending spreads could be found in the using them as

inputs into dynamic stochastic general equilibrium models that have been augmented to include a

micro-founded banking sector such as Goodfriend and McCallum (2007), or as a proxy for

increased financial frictions in macroeconomic models that lack a financial sector. Similar to the

studies by Repullo and Suarez (2004) and Ruthenberg and Landskroner (2008) for Basel II

framework, this mapping exercise attempts to illustrate the potential loan pricing implications for

the banks under the Basel III proposals.

A representative bank is designed to map the changes in the bank’s capital structure and to

understand how the composition of assets has an effect on the different components of net

income using the standard accounting relationships. Even though banks can adjust to the

regulatory reforms in several ways, this study supposes that they seek to pass on any additional

costs by raising the cost of loans to end-customers. It is believed that by computing the change in

net income and shareholder’s equity associated with the regulatory changes, we can compute the

increase in lending spreads required to achieve a given return on equity (ROE).

Of course, this approach is not without limitations. This approach does not formally model the

choices faced by the banks, nor does it offers estimates based on an optimization in a general

equilibrium setting. On other hand, as a substitute, it offers a starting point for understanding the

behavioral response of banks to a regulatory change in a most acceptable practical setting. It

enables and the researchers and the policy makers in determining the impact given a country’s

institutional setting, its banking sector and the elasticity of loan demand.

Though this approach can suggest the potential magnitude of the change in lending spreads,

deciding whether banks would be able to pass on these costs to borrowers is beyond the scope of

this study. Further, this approach focuses on the ‘steady state’ and does not consider the

transition period to the higher regulatory requirements. In the steady state, the supply of bank

credit is considered as exogenous and credit rationing is ignored. It is further implied that banks

price their loans to meet the marginal cost of loan production.

39

As this approach is understandably illustrative and general in nature and could be used to

estimate the impact on lending spreads from a change in bank’s capital structure, assets

composition, risk weighted assets and the corporate tax paid by these banks. Also, as this

approach does not rely much on the availability of very large datasets (which are obviously the

requirement in effective use of statistical methods); it is acceptable particularly for practitioners

for easy comprehension. Another advantage of this approach is that it explains how a given

change can alter the bank’s profitability and indicates to different possible behavioral responses

to the regulations including the unintended consequences. Further, this approach being a bottom-

up, micro-founded one, it offers a useful complement to top-down, structural models where the

modeling of the financial sector is necessarily parsimonious. Although this approach is founded

on several assumptions, all the assumptions are apparent, realistic, and simple and can be

modified to check the sensitivity of the results.

This approach focuses on only two elements of Basel III proposals viz., the first relating to

raising the minimum capital requirement and the second relating to enhanced liquidity

requirement. Firstly, though the previous Basel accords (Basel I and II) specified capital

adequacy rules for minimum capital adequacy ratios, however, they could not absorb the losses

during the recent crisis. In this backdrop, Basel III stipulates higher levels of tangible common

equity. In order to achieve this, banks need to increase their common equity with high- quality

capital. Although this can be achieved by deleveraging banks’ balance sheets by offloading

assets in the near term, but it does not change the fact that the relative share of common equity

and liabilities need to change.

Secondly, as per the Basel III framework, banks are required to meet two new liquidity standard

requirements viz., liquidity coverage ratio (LCR) and net stable funding ratio (NSFR). The LCR

is employed to identify the amount of unencumbered, high quality, liquid assets that can be made

use of to offset cash outflows. Basically, LCR aims to ensure that banks have adequate funding

liquidity to survive at least one month of a situation of stressed funding. As the related data

(requires details on a bank’s expected cash outflows over a one-month period) is not available

for researchers, it cannot be calibrated. The aim of NSFR is to address maturity mismatches

between assets and liabilities. NSFR establishes a minimum adequate amount of stable funding

based on the liquidity characteristics of a bank’s assets over a one-year horizon. This approach

estimates the cost to meet the NSFR. This approach mostly follows the footsteps of King (2010)

in estimating the impact of capital and liquidity requirements on the lending spreads.

This section of the study does not focus on measurement of credit risk, but on the relationships

between a bank’s capital structure, asset composition and their impact on bank’s profitability.

This greater level of detail is vital for understanding as to how the banks respond to the Basel III

regulatory reforms. Both theorists and researchers are quite concerned in understanding these

relationships, albeit they may be too complex to model parsimoniously. By offering greater

detail on the significance of different sources of capital, the present study also contributes to a

growing literature on bank capital structure choices and their impact on lending.

Elliott (2010) is one of the recent studies that has analyzed the loan pricing implications of the

proposed higher capital requirements under Basel III. By providing an accounting-based

analysis, Elliott (2010) has estimated how much the interest rate charged on loans would increase

if banks are required to hold more equity. However, in the stylized model of Elliot, banks hold

40

only loans funded by equity, deposits and wholesale funding and the interest rate on loan is

priced in order to meet a targeted ROE after covering for the cost of liabilities and other fixed

expenses (such as administrative costs and expected loan losses). Using the Federal Deposit

Insurance Corporation (FDIC) data for aggregate United States (US) banking system, Elliott has

calculated that if the ratio of common equity required for a given loan is raised by 2% with no

other changes, banks would need to raise lending spreads by 39 basis points (bps) to maintain the

target ROE of 15%. Further, if the ROE is allowed to fall to 14.5%, lending spread would have

raise only by 9 bps. Elliott summarizes that through a combination of actions the US banking

system would be able to adjust to higher capital requirements and ensure that they would not

have a strong effect on the pricing or availability of bank loans. The merit of the Elliott’s method

is in its simplicity as well as the intuition it provides on pricing of loans and the alternatives

available to banks to adjust to higher capital levels.

The approach of this section of the study is influenced largely by Elliott as well as King’s

approaches. By actual usage of the balance sheet data to compute the regulatory impact, it takes

into account the composition of the assets and liabilities as well the very important distinction

between the assets and risk weighted assets. Further, it models the cost meet the NSFR

unambiguously, elucidating the sensitivity of this computation to the inputs. This study makes an

attempt to compare two steady states, namely, one with and other one without the regulatory

requirements. Firstly, I consider the impact of higher capital requirements in isolation, and then

the cost to meet the NSFR is computed assuming the higher capital requirements have already

been met. Lastly, by considering the potential synergies between the two regulatory

enhancements, it models the capital and liquidity requirements together.

Lending Spreads - A more popular definition for the lending spread is that it is the difference

between the interest rate charged on loans and the rate paid on deposits (Repullo and Suarez,

2004). Goodfriend and McCallum (2007) determine the lending spread as the difference between

the uncollateralized lending rate and the interbank rate. Further, the rate charged by banks on

loans varies on several factors like; terms of the loan, the characteristics of the borrower, the

collateral provided and other costs associated with the loan.

Constructing a representative bank’s financial statements - Stylized balance sheet and income

statement data for scheduled commercial banks in India has been collected from Capitaline Plus

database, respective websites of the banks under study, RBI data- base, and Basel II Pillar III

disclosures of respective banks from their websites. The data employed for analysis is for the

period from 2002 to 2011 as the Capitaline Plus database provides complete datasets only for a

ten-year period IDBI Bank Ltd. in spite of its dual nature, it is also included amongst the public

sector banks. Public sector banks category also includes the State Bank of India and its associate

banks. Private sector banks also include the foreign banks operating in India. Scheduled

commercial banks (SCBs) include both the public and private sector banks.

41

Sample Distribution by Category of Scheduled Commercial Banks in India

Year Public Sector Banks Private Sector Banks SCBs

2002 30 87 117

2003 30 94 124

2004 30 93 123

2005 30 97 127

2006 30 88 118

2007 30 86 116

2008 30 83 113

2009 29 69 98

2010 29 87 116

2011 28 85 113

2014 27 68 95

Source: RBI Guidelines

The number of banks varies by year due to the merger, closure, or entry of a new foreign bank in

the year. Capitaline Plus database does not report RWAs directly in its datasets. Instead the

quantity of RWAs is collected from the more authenticate source; i.e. the Basel II Pillar III

disclosures of respective banks from their websites. Since the Capitaline Plus database presents

the data for category of banks, there was no problem of the outliers and the requirement of

winsorization of capital adequacy ratios to reduce the impact of outliers. Based on the data

described, a representative bank balance sheet and income statement is constructed for each

category of banks by taking the weighted average values for each component of the balance

sheet and the income statement for banks in each category of study. The weights are based on

total assets of the category of the banks.

Stylized Balance sheet and Income Statement of Scheduled Commercial Bank

BALANCE SHEET AVERAGE INCOME STATEMENT AVERAGE

Cash & Balances with RBI 5.59 Interest Income 6.21

Interbank Claims 4.09 Interest Expended 3.97

Investment & Securities 31.48 A. Net Interest Income 2.24

Loans & Advances 53.23 B. Other Income 1.28

Fixed Assets 0.99 C. Total Revenue (A+B) 3.52

Other Assets 4.63 D. Personnel Expenses 0.95

TOTAL ASSETS 100.00 E. Other Administrative Exp 1.37

Deposits by Customer (Retail 75.65 F. Operating Expenses (D+E) 2.32

42

& Corporate)

Interbank Funding Borrowings 9.16 G. Operating Profit (C-F) 1.20

Other Liabilities & Provisions 8.06 H. Tax Provisions 0.36

TOTAL LIABILITIES 92.88 I. Net Income (G-H) 0.84

Capital 1.05

Reserves Total 6.06

Equity Share Warrants 0.00

Equity Application Money 0.00 Return on Equity (ROE %) 0.15

Total Capital 7.12 Leverage Multiple 6.60

TOTAL LIAB & CAPITAL 100.00

Risk Weighted Asset / Total

Asset

65.77 Average Effective Tax Rate

(%)

33.00%

Source: RBI Guidelines

Loans & advances represent about more than half of the typical banks assets, followed by investments & securities (31.48%), cash and balances with RBI (5.59%), other assets (4.63%) and interbank claims (4.09%). These assets are funded mainly by deposits (75.65%), bank borrowings or interbank funding (9.6%). Shareholder’s equity is to the extent of 7.12%. RWAs constitute around 65.77% total assets on average. This ratio is significant when calculating the cost of meeting the higher capital requirement. Table-7.2.2 also shows the consolidated income statement for the representative bank. In terms of the composition of net income, net interest income is 2.24% with non-interest income also important at 1.28%. Total operating expenses constitute 2.32% of total assets. Personnel expenses represent around 41% of total operating expenses. Net income (or ROA) is 0.8%, implying that the average ROE is around 15%. The average historical corporate tax rate is accepted at 33%. 3.3 IMPACT OF BASEL III ON BANK CAPITAL:

Post crisis, on the global there have been sincere efforts towards improving the capital adequacy

of the banks. Capital adequacy levels across banks in most advanced economies were on a rise

between 2008 and 2010. For instance, by 2010, in the US, UK, Germany, and Japan, Capital to

Assets Ratio (CAR) was found to be above 15 per cent. The ratio showed a further increase for

US and German banks in the first quarter of 2011. However, among the major emerging

economies, the level of capital adequacy exhibited a moderate decline between 2009 and 2010,

with the exceptions of China, India, and Mexico. How- ever, Chinese banks experience a modest

decline in their capital positions by March 2011.

Levels of Capital Adequacy Ratios of Banks in Select Economies

Countries 2007 2008 2009 2010 2011 2014

Advanced Economies

France 10.2 10.5 12.4 12.3 …. 12.7

Germany 12.9 13.6 14.8 16.1 16.6 17.3

Greece 11.2 9.4 11.7 11.4 12.3 12.6

Italy 10.4 10.8 12.1 12.3 …. 12.7

Japan 12.3 12.4 15.8 16.7 …. ….

Portugal 10.4 9.4 10.5 10.2 10.5 10.7

Spain 11.4 11.3 12.2 11.8 …. 12.5

43

United Kingdom 12.6 12.9 14.8 15.9 …. 17.1

Unites States 12.8 12.8 14.3 15.3 15.5 ….

Emerging & Developing Economies

Brazil 18.7 18.2 18.9 17.6 18.2 …..

China 8.4 12 11.4 12.2 11.8 …

India 12.3 13 13.2 13.6 …. 14.1

Malaysia 14.4 15.5 18.2 17.5 16.4 16.2

Mexico 15.9 15.3 16.5 16.9 16.5 16.1

Russia 15.5 16.8 20.9 18.1 17.2 17.9 Source:Dr.Swamy“BaselIII:ImplicationonIndianBanking” & http://data.worldbank.org/indicator/FB.BNK.CAPA.ZS

Notwithstanding the progress in CAR, soundness of global banks remained a concern because of

a slow process of deleveraging and increasing levels of NPAs. There has been asymmetry in the

decline in banking sector leverage across countries after the crisis. The percentage of total capital

(and reserves) to total assets has been taken as an indicator of leverage in the banking system.

However, deleveraging has not gained any significant momentum in the banking systems of

other advanced European economies, viz., France, Germany, Portugal, Greece, and Spain,

treating 2008 as the reference point. Further, there was a general weakening of the asset quality

of top global banks. Further, according to RBI, financial soundness of the banking sector is a

sine qua non for the financial system’s stability in a bank-dominated country like India. In the

Indian context, the CAR, however, has weakened in 2010-11 over the previous year mostly due

to a decline in Tier II CAR ratio. Amongst the bank groups, foreign banks have registered the

highest CAR, followed by private sector banks and PSBs in 2010-11. Under Basel II also, the

CAR of SCBs remained well above the required minimum in 2010-11. This implies that, in the

short to medium term, SCBs are not constrained by capital in extending credit.

CRAR Levels of Indian Banking

Source: Dr. Swamy “Basel III: Implication on Indian Banking”

44

According to RBI (RBI 2011), Indian banks can comfortably cope with the proposed Basel III

framework, as they may not face huge difficulty in adjusting to the new capital rules in terms of

both quantum and quality. Quick estimates of RBI (based on the data furnished by banks in their

off-site returns) observe that the CAR of Indian banks under Basel III will be 11.7 per cent (as on

June 30, 2010) as compared with the required CAR under proposed Basel III at 10.5 per cent.

Capital Requirement Standards in Indian Context

Indian banks need to look for quality capital and also have to preserve the core capital as well as

use it more efficiently in the backdrop of Basel III implementation. Out of 10.50%, total equity,

the capital (equity + reserves) requirement has been hiked from the existing 2% to 7%. However,

Tier II capital that is hybrid capital (fund raising through mostly debt instruments) dumped from

4% to 2%. Further, with the stipulation of “counter-cyclical buffer” of up to 2.5%, the total CAR

requirement would raise upto 13%.

Comparison of Capital Requirement Standards

Minimum Capital Ratios Basel

III of

BCBs

Basel III

of RBI

Existing

RBI

norms

PSBs

Current

Position

Private

Banks

Current

Position

Minimum Common Equity Tier 1

(CET1)

4.5% 5.5% 3.6% 7.3% 11.2%

Capital Conservation Buffer

(CCB)

2.5% 2.5% - - -

Minimum CET1 + CCB 7% 8% 3.5% 7.3% 11.2%

Minimum Tier 1 Capital 7% 7% 3.6% 7.3% 11.2%

Minimum Total Capital Including

Buffer

8% 9% 6% 8.1% 11.5%

Minimum Total Capital + CCB 10.5% 11.5% 9.0% 12.1% 15.9%

Additional Counter Cyclical

Buffer in the form of Common

Equity Capital

0-

2.5%

0-2.5% NA NA NA

Source: Dr. Swamy “Basel III: Implication on Indian Banking”

Indian banks look comfortably placed. They will have to phase out those instruments from their

capital that are disallowed under Basel III.

Deductions from Capital – Basel III guidelines Vs. Existing RBI norms

Particulars BASEL III of RBI Existing RBI Norms Impact

Limit on deductions

Deductions would be

made if deductibles

exceed the 15% of

core capital at an

aggregate level, or

10% at the individual

item level.

All deductibles to be

deducted

Positive

45

Deductions from Tier

I or Tier II

All deductions from

core capital

50% of the deductions

from Tier I and

remaining 50% from

Tier II capital

(excepting DTAs and

intangibles where

100% deduction is

made from Tier I

capital

Negative

Treatment of

significant

investments in

common shares of

unconsolidated

financial

entities

Aggregated total

equity investment in

entities where banks

own more than 10%

of shares • (a) Less

than 10% of banks’

common equity – 250

risk

weight (b) More than

10 % will

be deducted from

common

equity

For investments upto:

(a) 30%:

125% risk weight or

risk weight as

warranted by external

rating

(b) 30-50%: 50%

deduction from Tier I

capital and 50% from

Tier II capital

Negative

Source: Dr. Swamy “Basel III: Implication on Indian Banking”

Dynamics of the Likely Impact on Bank Capital

The move to Basel III would enhance the need for capital based on the computation of risk-

weighted assets. In the current Indian banking context, risk- weighted assets are computed based

on standardized approaches. The shift from standardized approaches to risk-based approaches

would enable the Indian banks to rationalize the utilization of risk capital. Under credit risk,

transition from standardized approaches to foundation level internal-risk based approaches can

reduce the capital requirements considerably.

According to (BCBS, 2010), operational risk capital for non-AMA banks is higher than for AMA

banks, regard- less of the exposure indicator used for scaling. As such, under operation risk,

transition to advanced measurement approaches (AMA) is likely to increase the requirement of

market risk capital. Further, the introduction of incremental risk charge for credit risk in the

trading book and stressed VaR is expected to further increase risk-capital requirements.

Exposing the avail- able-for-sale (AFS) portfolio to market risk will further increase the

requirement for capital. Accordingly, transition towards advanced approaches to credit and

operational risk is expected to moderate capital requirements. However, there it is essential to

restructure market risk portfolios in line with the return on capital (RoC) deployed.

46

The new capital requirements as suggested under Basel III is a positive move for Indian banks as

it raises the core capital in the form of common equity, brings in the conservation and counter-

cyclical measures which in order to enable banks to conserve core capital in event of loss.

Though Indian banks are undoubtedly well capitalized, and maintaining a higher equity capital

ratio than stipulated under Basel III guidelines, they are indeed required to strengthen their

common equity after the relevant deductions. Investor preference would require the banks to

ensure that all the banks would have to maintain an equity capital ratio of higher than 7% by

2013.

Impact of Capital Standards

Basel III capital standards framework has indeed greatly revolutionized the capital structure of

banks putting onus on the banks to significantly raise their common equity, common equity,

additional Tier-I capital and Tier-II impact of the key factors of the Basel III regulations on

capital.

Impact of Key factors of capital standards on Equity tiers

Key Factors Impact on

Common

Equity

Capital

Impact on

Additional

Tier-I

Impact on

Additional

Tier-II

Increase in credit deployment Increase Increase Increase

Definition of common equity to exclude share

premium resulting from non-common equity

capital

Increase Decrease NA

Deductions made from common equity

instead of Tier 1 capital

Increase NA NA

Introduction of capital buffer Increase Increase Increase

Increase in capital requirements Increase Increase Increase

Transition to advanced approaches of credit

risk

Decrease Decrease Decrease

Transition to advanced approaches of

operation risk

Decrease Decrease Decrease

Transition to advanced measurement

approaches for measuring market risk

Increase --- ----

Source: Dr. Swamy “Basel III: Implication on Indian Banking”

Possible impact of capital standards on Indian banks

Key Recommendations of BASEL III Possible Impact

Increased quality of capital

May lead to capital raising by banks besides

retention of profits and resorting to reduced

Dividends

Increased quantity of capital

Banks will face additional capital requirement

and hence would raise common equity or

otherwise retain dividends

47

Reduced leverage ratio

This could lead to reduced lending apart from

banks be- coming very choosy in financing the

projects. Banks may reduce credit exposure

and potential credit losses through stricter

credit approval processes and, potentially

through lower limits, especially with regard to

bank exposures. Banks may focus on higher-

risk/higher return lending Pressure arises on

banks to sell low margin

assets

Source: Dr. Swamy “Basel III: Implication on Indian Banking”

BASEL III: Capital Projections for Indian Banks

In the wake of the new Basel III regime in the Indian context, it is attempted in this section of the

study to estimate the required additional minimum Tier-1 capital for the banks. This would

enable the banks to plan their capital raising activity in tune with regulatory requirements. This

exercise is carried out based on the data sourced from Capitaline plus database. As such, these

estimates at the best can be termed as approximations as these have data limitations with regard

to details required in the estimation process.

The methodology adopted includes the estimation process based on the reported Tier-1, Tier-2

capital, total capital and RWAs sourced from the Basel disclosures made by the banks in their

websites. The data for all the scheduled commercial banks has been collected accordingly and

grouped based on the bank groups namely; public sector banks and private banks. The important

assumption made in the estimation process is that RWAs of these banks grow by 10 percentage

points annually in Scenario-1 and 12% per annum in scenario-2 and 15% in Scenario-3. This

increase in RWAs is considered because of the reasoning that the banks grow their loan book

size approximately in the range of 20-25% and also considering the past trend of RWAs.

The estimates are presented in the tables here below. With an assumed growth of RWAs at 10%,

banks in India would require additional minimum tier-1 capital of INR 2,51,106.57 Crores. With

RWAs growth at 12% and 15%, the requirement would be in the order of INR 336390.41 crores

and INR 474168.60 crores respectively.

BASEL III Compliance – Required Minimum Capital

By Year PSBs Private Bank Total

Scenario – 1 with 10% growth in RWAs

2013 6173.54 0.00 6173.54

2014 16206.69 0.00 16206.69

2015 62103.88 2254.28 64358.16

2016 82070.48 5158.26 87228.74

2017 137120.89 13263.44 150384.33

2018 214104.12 37002.44 251106.57

Scenario – 2 with 12% growth in RWAs

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2013 7188.12 0.00 7188.12

2014 30403.23 5.48 30408.72

2015 75469.86 4694.77 80164.63

2016 119891.65 10265.87 130157.51

2017 184195.79 30028.58 214224.37

2018 274793.18 61597.23 336390.41

Scenario – 3 with 15% growth in RWAs

2013 7049.99 0.00 7049.99

2014 110613.04 1099.52 111712.56

2015 117188.41 8601.80 125790.21

2016 170369.71 22517.34 192887.06

2017 256646.88 51563.57 308210.45

2018 378891.07 95277.53 474168.60 Source: Dr. Swamy “Basel III: Implication on Indian Banking”

A study by rating agency Fitch estimates the additional capital requirements at about INR 2.5

lakh crores to 2.75 lakh crores for Indian banks. Moody’s Indian subsidiary ICRA said banks in

the country would re- quire equity capital ranging from Rs 3.9 lakh crores to Rs 5 lakh crores to

comply with Basel III standards. According to global research firm Macquarie, Indian banks

would have to go on a massive capital rising to the extent of over USD 30 billion (INR 1.67 lakh

crores) over the next five years to cater to their growth requirements and Basel-III

implementation charges. Similarly, according to the CARE study too banks have to raise equity

in the range of $45-55 bn to meet BASEL III core equity norms. According to CRISIL, Indian

banks may have to raise a total of about Rs 2.4 trillion to meet growth needs in compliance with

the Reserve Bank of India’s final guidelines on capital adequacy requirements under the new

Basel III norms by March 2018. Although the BASEL III regulations may not put immediate

stress on Indian banks to augment capital, an upsurge in credit off-take and market risk portfolios

is expected to give rise to an increase in the requirement of common equity.

3.4 NARSIMHAM COMMITTEE & ACTION TAKEN:

Measures to Strengthen the Banking System & Capital

The Committee suggests that pending the emergence of markets in India where market

risks can be covered, it would be desirable that capital adequacy requirements take into

account market risks in addition to the credit risks.

Action Taken - Banks are now required to assign capital for market risk. A risk weight of 2.5%

for market risk has been introduced on investments in Govt. and other approved securities with

effect from the year ending 31st March, 2000. For investments in securities outside SLR, a risk

weight of 2.5% for market risk has been introduced with effect from the year ending 31st March,

2001.

In the next three years, the entire portfolio of Government securities should be marked to

market and this schedule of adjustment should be announced at the earliest. It would be

appropriate that there should be a 5% weight for market risk for Govt. and approved

securities.

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Action Taken - The percentage of banks’ portfolio of Govt. and approved securities which is

required to be marked to market has progressively been increased. For the year ending 31st

March, 2000, banks were required to mark to market 75% of their investments. In order to align

the Indian accounting standards with the international best practices and taking into

consideration the evolving international developments, the norms for classification and valuation

of investments have been modified with effect from September 30, 2000. The entire investment

portfolio of banks is required to be classified under three categories, viz., Held to Maturity,

Available for Sale and Held for Trading. While the securities ‘Held for Trading’ and ‘Available

for Sale’ should be marked to market periodically, the securities ‘Held to Maturity’, which

should not exceed 25% of total investments are carried at acquisition cost unless it is more than

the face value, in which case, the premium should be amortized over a period of time.

The risk weight for a Government guaranteed advance should be the same as for other

advances. To ensure that banks do not suddenly face difficulties in meeting the capital

adequacy requirement, the new prescription on risk weight for Government guaranteed

advances should be made prospective from the time the new prescription is put in place.

Action Taken - In cases of Govt. guaranteed advances, where the guarantee has been invoked

and the concerned State Govt. has remained in default as on March 31, 2000, a risk weight of

20% on such advances, has been introduced. State Govts, Who continue to be in default in

respect of such invoked guarantees even after March 31, 2001, a risk weight of 100%, is being

assigned.

There is an additional capital requirement of 5% of the foreign exchange open position

limit. Such risks should be integrated into the calculation of risk weighted assets. The

Committee recommends that the foreign exchange open position limits should carry a

100% risk weight.

Action Taken - Risk weight of 100% has been introduced for foreign exchange open position

limits with effect from March 31, 1999.

The Committee believes that it would be appropriate to go beyond the earlier norms and

set new and higher norms for capital adequacy. The Committee accordingly recommends

that the minimum capital to risk assets ratio be increased to 10% from its present level of

8%. It would be appropriate to phase the increase as was done on the previous occasion.

Accordingly, the Committee recommends that an intermediate minimum target of 9% be

achieved by the year 2000 and the ratio of 10% by 2002. The RBI should also have the

authority to raise this further in respect of individual banks if in its judgments the

situation with respect to their risk profile warrants such an increase. The issue of

individual banks' shortfalls in the CRAR needs to be addressed in much the same way

that the discipline of reserve requirements is now applied, viz., of uniformity across weak

and strong banks.

Action Taken - The minimum capital to risk asset ratio (CRAR) for banks has been enhanced to

9% with effect from the year ending March 31, 2000.

In respect of PSBs, the additional capital requirement will have to come from either the

Govt. or the market. With the many demands on the budget and the continuing imperative

need for fiscal consolidation, subscription to bank capital funds cannot be regarded as a

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priority claim on budgetary resources. Those banks which are in a position to access the

capital market at home or abroad should, therefore, be encouraged to do so.

Action Taken - Banks are permitted to access the capital market. Till today, 12 banks have

already accessed capital market.

Asset Quality, NPAs and Directed Credit

The Committee recommends that an asset be classified as doubtful if it is in the

substandard category for 18 months in the first instance and eventually for 12 months and

loss if it has been so identified but not written off. These norms, which should be

regarded as the minimum, may be brought into force in a phased manner.

Action Taken - Banks have been advised that an asset will be classified as ‘doubtful’ if it has

remained in the substandard category for 18 months instead of 24 months as at present, by March

31, 2001. Banks have been permitted to achieve these norms for additional provisioning in

phases, as under : As on 31.3.2001 Provisioning of not less than 50% on the assets which have

become doubtful on account of the new norm. As on 31.3.2002 Balance of the provisions not

made during the previous year, in addition to the provisions needed as on 31.3.2002.

The Committee has noted that NPA figures do not include advances covered by

Government guarantees which have turned sticky and which in the absence of such

guarantees would have been classified as NPAs. The Committee is of the view that for

the purposes of evaluating the quality of asset portfolio such advances should be treated

as NPAs. If , however, for reason of the sovereign guarantee argument such advances are

excluded from computation, the Committee would recommend that Government

guaranteed advances which otherwise would have been classified as NPAs should be

separately shown as an aspect of fuller disclosure and greater transparency of operations.

Action Taken - Prudential norms in respect of advances guaranteed by State Governments where

guarantee has been invoked and has remained in default for more than two quarters has been

introduced in respect of advances sanctioned against State Government guarantee with effect

from April 1, 2000. Banks have been advised to make provisions for advances guaranteed by

State Governments which stood invoked as on March 31, 2000, in phases, during the financial

years ending March 31, 2000 to March 31, 2003 with a minimum of 25% each year.

Banks and financial institutions should avoid the practice of "ever greening" by making

fresh advances to their troubled constituents only with a view to settling interest dues and

avoiding classification of the loans in question as NPAs. The Committee notes that the

regulatory and supervisory authorities are paying particular attention to such breaches in

the adherence to the spirit of the NPA definitions and are taking appropriate corrective

action. At the same time, it is necessary to resist the suggestions made from time to time

for a relaxation of the definition of NPAs and the norms in this regard.

Action Taken - The RBI has reiterated that banks and financial institutions should adhere to the

prudential norms on asset classification, provisioning, etc. and avoid the practice of “ever

greening”.

The Committee believes that the objective should be to reduce the average level of net

NPAs for all banks to below 5% by the year 2000 and to 3% by 2002. For those banks

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with an international presence the minimum objective should be to reduce gross NPAs to

5% and 3% by the year 2000 and 2002, respectively, and net NPAs to 3% and 0% by

these dates. These targets cannot be achieved in the absence of measures to tackle the

problem of backlog of NPAs on a one time basis and the implementation of strict

prudential norms and management efficiency to prevent the recurrence of this problem.

Action Taken - This is the long-term objective which RBI wants to pursue. Towards this

direction, a number of measures have been taken to arrest the growth of NPAs: banks have been

advised to tone up their credit risk management systems; put in place a loan review mechanism

to ensure that advances, particularly large advances are monitored on an on-going basis so that

signals of weaknesses are detected and corrective action taken early; enhance credit appraisal

skills of their staff, etc. In order to ensure recovery of the stock of NPAs, guidelines for one-time

settlement have been issued in July, 2000.

The Committee is of the firm view that in any effort at financial restructuring in the form

of hiving off the NPA portfolio from the books of the banks or measures to mitigate the

impact of a high level of NPAs must go hand in hand with operational restructuring.

Cleaning up the balance sheets of banks would thus make sense only if simultaneously

steps were taken to prevent or limit the re-emergence of new NPAs which could only

come about through a strict application of prudential norms and managerial improvement.

Action Taken - Banks have been advised to take effective steps for reduction of NPAs and also

put in place risk management systems and practices to prevent re-emergence of fresh NPAs.

For banks with a high NPA portfolio, the Committee suggests consideration of two

alternative approaches to the problem as an alternative to the ARF proposal made by the

earlier CFS. In the first approach, all loan assets in the doubtful and loss categories,

which in any case represent bulk of the hard core NPAs in most banks, should be

identified and their realizable value determined. These assets could be transferred to an

Asset Reconstruction Company (ARC) which would issue to the banks NPA Swap Bonds

representing the realizable value of the assets transferred, provided the stamp duties are

not excessive. The ARC could be set up by one bank or a set of banks or even in the

private sector. In case the banks themselves decide to set up an ARC, it would need to be

ensured that the staff required by the ARC is made available to it by the banks concerned

either on transfer or on deputation basis, so that staff with institutional memory on NPAs

is available to ARC and there is also some rationalization of staff in the banks whose

assets are sought to be transferred to the ARC. Funding of such an ARC could be

facilitated by treating it on par with venture capital for purpose of tax incentives. Some

other banks may be willing to fund such assets in effect by securitizing them. This

approach would be worthwhile and workable if stamp duty rates are minimal and tax

incentives are provided to the banks.

Action Taken - The proposal to set up an Asset Reconstruction Company (ARC) on a pilot basis

to take over the NPAs of the three weak public sector banks, has been announced in the Union

Budget for 1999 – 2000. The modalities for setting up the ARC are being examined.

An alternative approach could be to enable the banks in difficulty to issue bonds which

could form part of Tier II capital. This will help the banks to bolster capital adequacy

which has been eroded because of the provisioning requirements for NPAs. As the banks

52

in difficulty may find it difficult to attract subscribers to bonds. Government will need to

guarantee these instruments which would then make them eligible for SLR investments

by banks and approve instruments by LIC, GIC and Provident Funds.

Action Taken - Banks are permitted to issue bonds for augmenting their Tier II capital.

Guarantee of the Govt. for these bonds is not considered necessary.

Directed credit has a proportionately higher share in NPA portfolio of banks and has been

one of the factors in erosion in the quality of bank assets. There is continuing need for

banks to extend credit to agriculture and small scale sector which are important segments

of the national economy, on commercial considerations and on the basis of

creditworthiness. In this process, there is scope for correcting the distortions arising out

of directed credit and its impact on banks’ assets quality.

Action Taken - The loans to agricultural and SSI sectors are now generally being granted on

commercial considerations and on the basis of creditworthiness of the borrower. Further, the

concessionality on interest rates for advances has been done away with, except for advances

under the DRI Scheme. While advances upto Rs.2 lakh should carry interest rate not exceeding

PLR, interest rates on advances of over Rs.2 lakh have been freed.

The Committee has noted the reasons why the Government could not accept the

recommendation for reducing the scope of directed credit under priority sector from 40%

to 10%. The Committee recognizes that the small and marginal farmers and the tiny

sector of industry and small businesses have problems with regard to obtaining credit and

some earmarking may be necessary for this sector. Under the present dispensation, within

the priority sector 10% of net bank credit is earmarked for lending to weaker sections. A

major portion of this lending is on account of Government sponsored poverty alleviation

and employment generation schemes. The Committee recommends that given the special

needs of this sector, the current practice may continue. The Branch Managers of banks

should, however, be fully responsible for the identification of beneficiaries under the

Government sponsored credit linked schemes. The Committee proposes that given the

importance and needs of employment oriented sectors like food processing and related

service activities in agriculture, fisheries, poultry and dairying, these sectors should also

be covered under the scope of priority sector lending. The Committee recommends that

the interest subsidy element in credit for the priority sector should be totally eliminated

and even interest rates on loans under Rs.2 lakh should be deregulated for scheduled

commercial banks as has been done in the case of Regional Rural Banks and co-operative

credit institutions. The Committee believes that it is the timely and adequate availability

of credit rather than its cost which is material for the intended beneficiaries. The

reduction of the preempted portion of banks' resources through the SLR and CRR would,

in any case, enlarge the ability of banks to dispense credit to these sectors.

Action Taken - As per the present stipulation, banks are required to lend 10% of net bank credit

(NBC) for weaker sections which includes all small and marginal farmers, all IRDP and DRI

borrowers, borrowers under SUME etc. The Committee has recommended that the present

stipulation may continue. As recommended by the Committee, some activities like food

processing, related service activities in agriculture, fisheries, poultry, dairying have been brought

under priority sector. Under the existing dispensation, Units in sectors like food processing, etc.,

satisfying either the definition of SSI [the ceiling of investment in plant and machinery (original

53

cost) for a unit being classified under this category has since been enhanced to Rs. 3 crore from

Rs.60 lakhs / Rs.75 laks for ancillaries and export oriented units] or small business are already

covered under priority sector. No further changes are considered necessary, as larger units need

not be given any advantage by enlarging the scope of definition of priority sector advances. As a

first step towards deregulation of interest rates on credit limits up to R.2 lakh and eliminating

interest subsidy element in credit for priority sector, in the Monetary and Credit Policy

announced in April, 1998, it has been stipulated that interest rates on loans up to Rs.2 lakh

should not exceed PLR as against the earlier stipulation of ‘not exceeding 13.5%’, for credit

limits of Rs.25, 000--Rs.2 lakh and 12% for credit limit up to Rs.25,000. Banks are free to decide

their PLR subject to their obtaining the prior approval of their Boards therefore. As the PLR

differs from bank to bank, depending on their cost of funds and competitive strategies, the

measure is a step towards deregulation of interest rates. Thus the recommendation of the

Committee has been implemented in spirit. It may be stated that except for loans under DRI there

is no subsidization of interest.

Prudential Norms and Disclosure Requirements

With regard to income recognition, in India, income stops accruing when interest or

installment of principal is not paid within 180 days. The Committee believes that we

should move towards international practices in this regard and recommends the

introduction of the norm of 90 days in a phased manner by the year 2002.

Action Taken - The recommendation of the Committee that we should move towards

international practices in regard to income recognition is accepted in principle. However,

tightening of the prudential norms should be made keeping in view the existing legal framework,

production and payment cycles, business practices, the predominant share of agriculture in the

country’s economy, etc. The production and repayment cycles in the industry in the country

generally involve a period of not less than from 4 to 6 months. A large number of SSIs also have

difficulties in timely realization of their bills drawn on the suppliers. These have to be taken into

account while contemplating any change in the norm. Implementation of the recommendation

would have serious implications on the asset portfolio of banks and even good quality borrowers

and find it difficult to comply with the norms recommended. There have been representations

from banks and financial institutions seeking relaxations in the above instructions by increasing

the period to 3-4 quarters. Keeping in view the current industrial scenario, implementation of the

recommendation would have serious implications even to healthy borrowers. Furthermore,

interest on advances is calculated by banks at quarterly rests, keeping in view the large number

and volume of accounts, if we have to implement the recommendation.

At present, there is no requirement in India for a general provision on standard assets. In

the Committee’s view a general provision, say, of 1% would be appropriate and RBI

should consider its introduction in a phased manner.

Action Taken - To start with, a general provision on standard assets of a minimum of 0.25%

from the year ended March 31, 2000 introduced.

There is a need for disclosure, in a phased manner, of the maturity pattern of assets and

liabilities, foreign currency assets and liabilities, movements in provision account and

NPAs. The RBI should direct banks to publish, in addition to financial statements of

independent entities, a consolidated balance sheet to reveal the strength of the group. Full

54

disclosure would also be required of connected lending and lending to sensitive sectors.

Furthermore, it should also ask banks to disclose loans given to related companies in the

bank's balance sheets. Full disclosure of information should not be only a regulatory

requirement. It would be necessary to enable a bank’s creditors, investors and rating

agencies to get a true picture of its functioning – an important requirement in a market

driven financial sector.

Action Taken - Banks have been advised to disclose the following information, in addition to the

existing disclosures, in the ‘Notes on Accounts’ to the balance sheet from the accounting year

ended March 31, 2000.

Maturity pattern of loans and advances,

Maturity pattern of investment securities,

Foreign currency assets and liabilities

Movement in NPAs,

Maturity pattern of deposits

Maturity pattern of borrowings

Lending to sensitive sectors as defined from time to time

Banks should also pay greater attention to asset liability management to avoid

mismatches and to cover, among others, liquidity and interest rate risks.

Action Taken - Detailed guidelines issued to banks on asset –liability management.

Implementation of these guidelines would enable banks to avoid liquidity mismatches as also to

cover, among others, liquidity and interest rate risks.

Banks should be encouraged to adopt statistical risk management techniques like Value-

at-Risk in respect of balance sheet items which are susceptible to market price

fluctuations, forex rate volatility and interest rate changes. While the Reserve Bank may

initially, prescribe certain normative models for market risk management, the ultimate

objective should be that of banks building up their own models and RBI backtesting them

for their validity on a periodical basis.

Action Taken - Comprehensive guidelines have been issued to enable banks to put in place

appropriate risk management systems. Banks have also been advised to adopt statistical risk

management techniques like Value-at-Risk (which is a statistical method of assessing the

potential maximum loss from a credit or investment exposure, over a definite holding period at a

given confidence level) or other models appropriate to their level of business operation.

Systems and Methods in Banks

Banks should bring out revised Operational Manuals and update them regularly, keeping

in view the emerging needs and ensure adherence to the instructions so that these

operations are conducted in the best interest of a bank and with a view to promoting good

customer service. These should form the basic objective of internal control systems, the

major components of which are: (I) Internal Inspection and Audit, including concurrent

audit, (2) Submission of Control Returns by branches/controlling offices to higher level

offices (3) Visits by controlling officials to the field level offices (4) Risk management

systems (5) Simplification of documentation, procedure and of inter office

communication channels.

55

Action Taken - Banks have been advised to bring out revised Operative Manuals and update

them regularly. Banks have confirmed having brought out revised Manuals.

An area requiring close scrutiny in the coming years would be computer audit, in view of

large scale usage and reliance on information technology.

Action Taken - Banks have been advised to set up EDP Audit Cell, as part of their Inspection

Department.

There is enough international experience to show the dangers to an institution arising out

of inadequate reporting to and checking by the back offices of trading transactions and

positions taken. Banks should pay special attention to this aspect.

Action Taken - RBI had in 1992 emphasized to banks the importance of an effective

management reporting system, segregation of the trading and back office functions, etc. The

efficacy of the systems put in place by banks is being constantly reviewed by the RBI through

periodical inspections.

There is need to institute an independent loan review mechanism especially for large

borrowal accounts and systems to identify potential NPAs. It would be desirable that

banks evolve a filtering mechanism by stipulating in-house prudential limits beyond

which exposures on single/group borrowers are taken keeping in view their risk profile as

revealed through credit rating and other relevant factors. Further, in-house limits could be

thought of to limit the concentration of large exposures and industry/sector/geographical

exposures within the Board approved exposure limits and proper overseeing of these by

the senior management/ boards.

Action Taken - Banks have been advised to put in place an independent Loan Review

Mechanism, as recommended by the Committee.

The Committee feels that the present practice of RBI selection of statutory auditors for

banks with Board of Directors having no role in the appointment process, is not

conducive to sound corporate governance. We would recommend that the RBI may

review the existing practice in this regard. It may also reassess the role and function of

the Standing Advisory Committee on Bank Audit in the light of the setting up of the

Audit Committee under the aegis of the Board for Financial Supervision.

Action Taken - The recommendation was put up before the Audit Sub-Committee of the Board

for Financial Supervision which was of the view that the existing practice should continue.

The Committee notes that public sector banks and financial institutions have yet to

introduce a system of recruiting skilled manpower from the open market. The Committee

believes that this delay has had an impact on the competency levels of public sector

banks in some areas and they have consequently lost some ground to foreign banks and

the newly set up private sector banks. The Committee urges that this aspect be given

urgent consideration and in case there is any extant policy driven impediments to

introducing this system, appropriate steps be taken by the authorities towards the needed

deregulation. Banks have to tone up their skills base by resorting, on an ongoing basis, to

lateral induction of experienced and skilled personnel, particularly for quick entry into

new activity/areas. The Committee notes that there has been considerable decline in the

56

scale of merit-based recruitment even at the entry level in many banks. The concept of

direct recruitment itself has been considerably diluted by many PSBs including the State

Bank of India by counting internal promotions to the trainee officers' cadre as direct

recruitment. The Committee would strongly urge the managements of public sector banks

to take steps to reverse this trend. The CFS had recommended that there was no need for

continuing with the Banking Service Recruitment Boards insofar as recruitment of

officers was concerned. This Committee, upon examination of the issue, reaffirms that

recommendation. As for recruitment in the clerical cadre, the Committee recommends

that a beginning be made in this regard by permitting three or four large. well-performing

banks, including State Bank of India, to set up their own recruitment machinery for

recruiting clerical staff. If the experience under this new arrangement proves satisfactory,

it could then pave the way for eventually doing away completely with the Banking

Service Recruitment Boards.

Action Taken - The public sector banks have been permitted to recruit from the open market or

by way of campus recruitment, skilled personnel in areas like information technology, risk

management, treasury operations, etc. As regards the recommendation in regard to discontinuing

the practice of recruitment of officers through Banking Services Recruitment Boards, Govt. may

furnish comments.

It seems apparent that there are varying levels of over manning in public sector banks.

The managements of individual banks must initiate steps to measure what adjustments in

the size of their work force are necessary for the banks to remain efficient, competitive

and viable. Surplus staff, where identified, would need to be redeployed on new business

and activities, where necessary after suitable retraining. It is possible that even after this

some of the excess staff may not be suitable for redeployment on grounds of aptitude and

mobility. It will, therefore, be necessary to introduce an appropriate Voluntary

Retirement Scheme with incentives. The managements of banks would need to initiate

dialogue in this area with representatives of labour.

Action Taken - While some of the public sector banks have introduced VRS after consultations

with Employees’ Unions, others are in the process of introducing such schemes.

The Committee would urge the managements of Indian banks to review the changing

training needs in individual banks keeping in mind their own business environment and

to address these urgently.

Action Taken - Banks have been advised to review the training needs and give more focus to

emerging areas like Credit Management, Treasury Management, Risk Management, Information

Technology, etc.

Structural Issues

The Committee has taken note of the twin phenomena of consolidation and convergence

which the financial system is now experiencing globally. In India also banks and DFIs

are moving closer to each other in the scope of their activities. The Committee is of the

view that with such convergence of activities between banks and DFIs, the DFIs should,

over a period of time, convert themselves to banks. There would then be only two forms

of intermediaries, viz. banking companies and non-banking finance companies. If a DFI

does not acquire a banking license within a stipulated time it would be categorized as a

57

non-banking finance company. A DFI which converts to a bank can be given some time

to phase in reserve requirements in respect of its liabilities to bring it on par with the

requirements relating to commercial banks. Similarly, as long as a system of directed

credit is in vogue a formula should be worked out to extend this to DFIs which have

become banks.

Action Taken - Based on the recommendations of the Khan Working Group on Harmonization

of the Role and Operations of banks and DFIs, RBI had released a Discussion Paper in January,

1999 for wider public debate. The feedback on the discussion paper indicated that while

universal banking is desirable from the point of view of efficiency of resource use, there is need

for caution in moving towards such a system by banks and DFIs. Major areas requiring attention

are the status of financial sector reforms, the state of preparedness of concerned institutions, the

evolution of regulatory-regime and above all a viable transition path for institutions which are

desirous of moving in the direction of universal banking. The Monetary and Credit Policy for the

year 2000 –2001 proposed to adopt the following broad approach for considering proposals in

this area:

The principle of “Universal Banking” is a desirable goal and some progress has

already been made by permitting banks to diversify into investments and long-

term financing and the DFIs to lend for working capital, etc. However, banks have

certain special characteristics and as such any dilution of RBI’s prudential and

supervisory norms for conduct of banking business would be inadvisable. Further,

any conglomerate, in which a bank is present, should be subject to a consolidated

approach to supervision and regulation.

Any DFI, which wishes to do so, should have the option to transform into bank

(which it can exercise), provided the prudential norms as applicable to banks are

fully satisfied. To this end, a DFI would need to prepare a transition path in order

to fully comply with the regulatory requirement of a bank. The DFI concerned

may consult RBI for such transition arrangements. Reserve Bank will consider

such requests on a case by case basis.

Mergers between banks and between banks and DFIs and NBFCs need to be based on

synergies and location and business specific complementarities of the concerned

institutions and must obviously make sound commercial sense. Mergers of public sector

banks should emanate from management of banks with Govt. as the common shareholder

playing a supportive role. Such mergers, however, can be worthwhile if they lead to

rationalization of workforce and branch network; otherwise the mergers of public sector

banks would tie down the managements with operational issues and distract attention

from the real issue. It would be necessary to evolve policies aimed at "rightsizing" and

redeployment of the surplus staff either by way of retraining them and giving them

appropriate alternate employment or by introducing a VRS with appropriate incentives.

This would necessitate the cooperation and understanding of the employees and towards

this direction, managements should initiate discussions with the representatives of staff

and would need to convince their employees about the intrinsic soundness of the idea, the

competitive benefits that would accrue and the scope and potential for employees' own

professional advancement in a larger institution. Mergers should not be seen as a means

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of bailing out weak banks. Mergers between strong banks/FIs would make for greater

economic and commercial sense and would be a case where the whole is greater than the

sum of its parts and have a "force multiplier effect"

Action Taken - The recommendation has been noted. A nonbanking finance company has since

been permitted to merge with a bank. Two banks in the private sector have also merged based on

synergies and business specific complementarities.

A ‘weak bank’ should be one whose accumulated losses and net NPAs exceed its net

worth or one whose operating profits less its income on recapitalization bonds is negative

for three consecutive years. A case by case examination of the weak banks should be

undertaken to identify those which are potentially revivable with a programme of

financial and operational restructuring. Such banks could be nurtured into healthy units

by slowing down on expansion, eschewing high cost funds/borrowings, judicious

manpower deployment, recovery initiatives, containment of expenditure etc. The future

set up of such banks should also be given due consideration. Merger could be a solution

to the problem of weak banks but only after cleaning up their balance sheets. If there is

no voluntary response to a takeover of these banks, it may be desirable to think in terms

of a Restructuring Commission for such public sector banks for considering other options

including restructuring, merger amalgamation or failing these closures. Such a

Commission could have terms of reference which, inter alia, should include suggestion of

measures to safeguard the interest of depositors and employees and to deal with possible

negative externalities. Weak banks which on a careful examination are not capable of

revival over a period of three years should be referred to the Commission.

Action Taken - In addition to the two definitions for identifying ‘weak’ banks recommended by

the Committee, RBI monitors banks to identify ‘potential weakness’ on the basis of five more

parameters (related to solvency, profitability and earnings) as recommended by the Working

Group on Restructuring of Weak Public Sector Banks (Chairman : Shri M.S.Verma ). In respect

of weak banks, a bank-specific restructuring programme aimed at turning around the bank by

reducing their cost of operation, and improving income levels, has been put in place. The

recommendation for setting up of a Restructuring Commission has not been considered.

However, the Union Budget for 2000 – 2001 has proposed setting up of a Financial

Restructuring Authority for a weak or potentially weak bank.

The policy of licensing new private banks (other than local area banks) may continue.

The startup capital requirements of Rs.100 crore were set in 1993 and these may be

reviewed. The Committee would recommend that there should be well defined criteria

and a transparent mechanism for deciding the ability of promoters to professionally

manage the banks and no category should be excluded on a priori grounds. The question

of a minimum threshold capital for old private banks also deserves attention and mergers

could be one of the options available for reaching the required capital thresholds. The

Committee would also, in this connection, suggest that as long as it is laid down (as now)

that any particular promoter group cannot hold more than 40% of the equity of a bank,

any further restriction of voting rights by limiting it to 10% may be done away with.

Action Taken - The policy of licensing new banks in the private sector has been reviewed by an

in-house Working Group set up by RBI. Based on the recommendations of the Working Group,

the licensing policy is being revised.

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The Committee is of the view that foreign banks may be allowed to set up subsidiaries or

joint ventures in India. Such subsidiaries or joint ventures should be treated on par with

other private banks and subject to the same conditions with regard to branches and

directed credit as these banks.

Action Taken - The recommendation has been examined. It has been felt that branch presence by

foreign banks would be better for the reason that the parent bank would stand ready to support

the branch in times of distress. Since subsidiaries would be set up as a joint stock companies with

limited liability, the parent bank’s liability to its subsidiary would be limited to its shareholding.

In the case of branches, the parent bank has responsibility both towards capital and management

whereas in the case of subsidiaries, the parent bank’s responsibility towards capital is limited.

All NBFCs are statutorily required to have a minimum net worth of Rs.25 lakhs if they

are to be registered. The Committee is of the view that this minimum figure should be

progressively enhanced to Rs.2 crores which is permissible now under the statute and that

in the first instance it should be raised to Rs.50 lakhs.

Action Taken - In respect of new NBFCs, which seek registration with the RBI and commence

the business on or after April 20,1999 the criteria in regard to minimum net worth has been

increased to Rs.2 crore, vide the Monetary and Credit Policy for the year 1999-2000.

Deposit insurance for NBFCs could blur the distinction between banks, which are much

more closely regulated, and the non- banks as far as safety of deposit is concerned and

consequently lead to a serious moral hazard problem and adverse portfolio selection. The

Committee would advise against any insurance of deposits with NBFCs.

Action Taken - The recommendation on not providing insurance cover for deposits with NBFCs

has been noted.

RBI should undertake a review of the current entry norms for urban cooperative banks

and prescribe revised prudent minimum capital norms for these banks. Though

cooperation is a state subject, since UCBs are primarily credit institutions meant to be run

on commercial lines, the Committee recommends that this duality in control should be

dispensed with. It should be primarily the task of the Board of Financial Supervision to

set up regulatory standards for Urban Cooperative Banks and ensure compliance with

these standards through the instrumentality of supervision.

Action Taken - The norms with regard to minimum capital requirements for urban cooperative

banks (UCBs) have been revised with effect from 1st April, 1998. Implementation of this

recommendation on doing away with duality of control over UCBs would involve amendments

to State Cooperative Societies Acts. The Government therefore, has to consider.

The Committee is of the view that there is need for a reform of the deposit insurance

scheme. In India, deposits are insured upto Rs.1 lakh. There is no need to increase the

amount further. There is, however, need to shift away from the 'flat' rate premiums to

'risk based' or 'variable rate' premiums. Under risk based premium system all banks

would not be charged a uniform premium. While there can be a minimum flat rate which

will have to be paid by all banks on all their customer deposits, institutions which have

riskier portfolios or which have lower ratings should pay higher premium. There would

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thus be a graded premium. As the Reserve Bank is now awarding CAMELS ratings to

banks, these ratings could form the basis for charging deposit insurance premium.

Action Taken - This has been accepted for implementation. The Working Group on Deposit

Insurance appointed by RBI has recommended the modalities for switching over to ‘risk based’

premium for deposit insurance and the recommendations are under examination.

The Committee is of the view that the inter-bank call and notice money market and inter-

bank term money market should be strictly restricted to banks. The only exception should

be the primary dealers who, in a sense, perform a key function of equilibrating the call

money market and are formally treated as banks for the purpose of their inter-bank

transactions. All the other present non-bank participants in the interbank call money

market should not be provided access to the inter-bank call money market. These

institutions could be provided access to the money market through different segments.

Action Taken - The phasing out of non-bank participants from inter-bank Call/Notice Money

market will be synchronized with the development of repo market. Keeping in view this

objective, RBI has widened the scope of repo market to include all entities having SGL Account

and Current Account in Mumbai, thus increasing the number of eligible non-bank entities to 64.

Further, the permission given to non-bank entities to lend in the call/notice money market by

routing their operations through PDs has been extended upto June, 2001. RBI aims to move

towards a pure interbank (including PDs) call/notice money market. With a view to further

deepening the money market and enable banks, PDs and AIFIs to hedge interest rate risk, these

entities are allowed to undertake FRA/IRSs as a product for their own balance sheet management

and for market making purposes. Mutual Funds, in addition to corporate are also permitted to

undertake FRAs/IRSs with these players. This measure is, inter alia, expected to help

development of a term money market.

There must be clearly defined prudent limits beyond which banks should not be allowed

to rely on the call money market. This would reduce the problem of vulnerability of

chronic borrowers. Access to the call market should be essentially for meeting unforeseen

swings and not as a regular means of financing banks’ lending operations.

Action Taken - RBI has advised banks to put in place comprehensive ALM System with effect

from 1.4.1999. ALM would effectively put a cap on reliance on call money market.

The RBI support to the market should be through a Liquidity Adjustment Facility under

which the RBI would periodically, if necessary daily reset its Repo and Reverse Repo

rates which would in a sense provide a reasonable corridor for market play. While there is

much merit in an inter-bank reference rate like a LIBOR, such a reference rate would

emerge as banks implement sound liquidity management facilities and the other

suggestions made above are implemented. Such a rate cannot be anointed, as it has to

earn its position in the market by being a fairly stable rate which signals small discrete

interest rate changes to the rest of the system.

Action Taken - The ILAF (Interim Liquidity Adjustment Facility) introduced earlier has served

its purpose as a transitional measure for providing reasonable access to liquid funds at set rates of

interest. In view of the experience gained in operating the interim scheme last year, an Internal

Group was set up by RBI to consider further steps to be taken. Following the recommendation of

the Internal Group, it was announced in the Monetary and Credit Policy Measures in April, 2000

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to proceed with the implementation of a full-fledged LAF. The new scheme will be introduced

progressively in convenient stages in order to ensure smooth transition.

In the first stage, with effect from June 5, 2000, the Additional CLF and level II

support to PDs will be replaced by variable rate repo auctions with same day

settlement.

In the second stage, the effective date for which will be decided in consultation

with banks and PDs, CLF and level I liquidity support will also be replaced by

variable rate repo auctions. Some minimum liquidity support to PDs will be

continued but at interest rate linked to variable rate in the daily repos auctions as

determined by RBI from time to time.

With full computerization of Public Debt Office (PDO) and introduction of RTGS

expected to be in place by the end of the current year, in the third stage, repo

operations through electronic transfers will be introduced. In the final stage, it will

be possible to operate LAF at different timings of the same day.

The minimum period of FD be reduced to 15 days and all money market instruments

should likewise have a similar reduced minimum duration

Action Taken -The minimum maturity of CDs has been reduced to 15 days

Foreign institutional investors should be given access to the Treasury bill market.

Broadening the market by increasing the participants would provide depth to the market.

Action Taken -FIIs have been permitted to invest in Treasury Bills, vide Monetary and Credit

Policy announced in April 1998.

With the progressive expansion of the forward exchange market, there should be an

endeavour to integrate the forward exchange market with the spot forex market by

allowing all participants in the spot forex market to participate in the forward market upto

their exposures. Furthermore, the forex market, the money market and the securities

should be allowed to integrate and the forward premia should reflect the interest rate

differential. As instruments move in tandem in these markets the desiderative of a

seamless and vibrant financial market would hopefully emerge.

Action Taken -With effect from June 11, 1998 Foreign Institutional investors were permitted to

take forward cover from Authorized Dealers to the extent of 15 per cent of their existing

investment as on that date. Any incremental investment over the level prevailing on June 11,

1998 was also made eligible for forward cover. The Monetary and Credit Policy for 1999-2000

has further simplified the procedure by linking the above mentioned limits to FIIs’ outstanding

investments as on March 31, 1999. In other words, 15 per cent of outstanding investment on

March 31, 1999 as well as the entire amount – 100 per cent - of any additional investment made

after this date will be eligible for forward cover. Further, any FII which has exhausted the limits

mentioned above can apply to RBI for additional forward cover for a further 15 percent of their

outstanding investments in India at the end of March 1999.

Rural and Small Industrial Credit

The Committee also recommends that a distinction be made between NPAs arising out of

client specific and institution specific reasons and general (agro-climatic and

environmental issues) factors. While there should be no concession in treatment of NPAs

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arising from client specific reasons, any decision to declare a particular crop or product or

a particular region to be distress hit should be taken purely on techno economic

consideration by a technical body like NABARD.

Action Taken -In the event of adverse agro-climatic and environmental factors, covering all

natural calamities, outstanding loans are converted/rescheduled/rephrased suitably. Agricultural

advances so rescheduled are provided relief for NPA classification. The decision to declare a

particular crop or product or a particular region as distress hit is at present vested in the

concerned District Administration Authority and the desirability of consulting NABARD which

is the technical body, before taking the decision, would be examined.

As a measure of improving the efficiency and imparting a measure of flexibility the

committee recommends consideration of the debt securitization concept within the

priority sector. This could enable banks, which are not able to reach the priority sector

target to purchase the debt from the institutions, which are able to lend beyond their

mandated percentage.

Action Taken -The recommendation of the Committee, which basically aims at ensuring that the

target for priority sector lending is achieved by each of the banks, has been re-examined. As of

March 2000, all public sector banks with the exception of UCO Bank have achieved the priority

sector lending target individually and the public sector banks as a Group has exceeded the target

at the macro level. The UCO Bank is short of achievement only marginally. Furthermore, every

year the Govt. has been settings up a Rural Infrastructure Development Fund (RIDF) in which all

banks which do not achieve the priority sector target contribute the amount of shortfall. Thus all

banks, directly or indirectly are able to fulfill the priority sector lending targets. Though the

concept of debt securitization is a novel idea, it will not have any practical application since it

will not help in augmenting the flow of credit to the priority sector nor will it help in addressing

the question of regional imbalances. It has, therefore, been decided that the recommendation

need not be considered for the present.

Banking policy should facilitate the evolution and growth of micro credit institutions

including LABs which focus on agriculture, tiny and small scale industries promoted by

NGOs for meeting the banking needs of the poor. Third-tier banks should be promoted

and strengthened to be autonomous, vibrant, effective and competitive in their operations.

Action Taken -In principle approval has been granted for setting up of 10 Local Area Banks

(LABs). Out of these, on account of non-compliance with the terms and conditions, the ‘in

principle’ approvals given to 4 banks were withdrawn. Of the remaining, 4 LABs have already

started functioning after obtaining licenses under Section 22 of Banking Regulation Act, 1949.

Banks should devise appropriate criteria suited to the small industrial sector and be

responsive to its genuine credit needs but this should not be by sacrificing cannons of

sound banking. Borrowers also need to accept credit discipline. There is also need to

review the present institutional set up of state level financial/industrial development

institutions.

Action Taken -48 recommendations of the S.L. Kapur Committee conveyed to banks for

implementation. As a further impetus to the flow of credit, banks have been advised that the

credit requirement of SSIs having credit limits upto Rs.5 crore, instead of Rs.4 crore, may be

assessed on the basis of 20% of the projected annual turnover.

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Regulations and Supervisions

The Committee recommends that to improve the soundness and stability of the Indian

banking system, the regulatory authorities should make it obligatory for banks to take

into account risk weights for market risks. The movement towards greater market

discipline in a sense would transform the relationship between banks and the regulator.

By requiring greater internal controls, transparency and market discipline, the supervisory

burden itself would be relatively lighter.

Action Taken -Banks are now required to assign capital for market risk. The disclosure

requirements of banks have been strengthened.

There is a need for all market participants to take note of the core principles and to

formally announce full accession to these principles and their full and effective

implementation.

Action Taken -We have endorsed the ‘Core Principles for Effective Banking Supervision’ and

complied with almost all of them. Our compliance with the Core Principles has been rated as

satisfactory by IMF Mission.

Proprietorial concerns in the case of public sector banks impact on the regulatory

function leading to a situation of ‘regulatory capture’ affecting the quality of regulation.

Action Taken -The prudential / regulatory norms stipulated by RBI are applicable to public

sector banks, private sector banks and foreign banks uniformly.

The Committee recommends that the regulatory and supervisory authorities should take

note of the developments taking place elsewhere in the area of devising effective

regulatory norms and to apply them in India taking into account the special

characteristics but not in any way diluting the rigor of the norms so that the prescriptions

match the best practices abroad. It is equally important to recognize that pleas for

regulatory forbearance such as waiving adherence to the regulations to enable some

(weak) banks more time to overcome their deficiencies could only compound their

problems for the future and further emasculate their balance sheets.

Action Taken -The Regulatory / Supervisory norms have been formulated taking into account

the best international practices. RBI has not waived adherence to the regulatory norms by any

individual bank or category of banks.

An important aspect of regulatory concern should be ensuring transparency and

credibility particularly as we move into a more market driven system where the market

should be enabled to form its judgments about the soundness of an institution. There

should be punitive penalties both for the inaccurate reporting to the supervisor or

inaccurate disclosures to the public and transgressions in spirit of the regulations.

Action Taken -We are moving towards greater transparency and Statutory Auditors of banks are

now under the obligation to report on the deviations from adherence to the prudential norms

prescribed by RBI in their ‘Notes to Accounts’. These observations are followed up by the RBI

with the concerned banks. In terms of the provisions of Section 47A of the B.R. Act, 1949, as

amended in 1994, the RBI can impose a penalty not exceeding Rs. 5 lakh or twice the amount

involved in such contravention or default where such amount is quantifiable whichever is more

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and where such contravention or default is a continuing one, a further penalty which may extent

to Rs.25000 for every day after the first day when the contravention or default continues.

The Committee recommends that an integrated system of regulation and supervision be

put in place to regulate and supervise the activities of banks, financial institutions and

non banking finance companies (NBFCs). The functions of regulation and supervision

are organically linked and we propose that this agency be renamed as the Board for

Financial Regulation and Supervision (BFRS) to make this combination of functions

explicit. An independent regulatory supervisory system which provides for a closely

coordinated monetary policy and banking supervision would be the ideal to work

towards.

Action Taken -BFS needs to be strengthened before regulatory functions are vested with it. It

was, therefore, felt that while the Committee’s recommendations to set up an agency named

Board for Financial Regulation and Supervision (BFRS) to provide an integrated system of

regulation and supervision over banks, FIs and NBFCs could be a long term objective. For the

time being, BFS may continue with its present mandate.

Legal and Legislative Framework

With the advent of computerization there is need for clarity in the law regarding the

evidentiary value of computer generated documents. The Shere Committee had made

some recommendations in this regard and the Committee notes that the Government is

having consultations with public sector banks in this matter. With electronic funds

transfer several issues regarding authentication of payment instruments, etc. require to be

clarified. The Committee recommends that a group be constituted by the Reserve Bank to

work out the detailed proposals in this regard and implement them in a time bound

manner.

Action Taken -The Group set up by the RBI has submitted its Report and the recommendations

are in various stages of implementation.

Although there is a provision in our legislation effectively prohibiting loans by banks to

companies in which their directors are interested as directors or employees of the latter

with liberalization and the emergence of more banks on the scene and with the induction

of private capital through public issue in some of the nationalized banks there is a

possibility that the phenomenon of connected lending might reappear even while

adhering to the letter of law. It is necessary to have prudential norms which are addressed

to this problem by stipulating concentration ratios in terms of which no bank can have

more than a specified proportion of its net worth by way of lending to any single

industrial concern and a higher percentage in respect of lending to an industrial group. At

present, lending to any single concern is limited to 25% of a bank’s capital and free

reserves. This would seem to be appropriate along with the existing enhanced figure of

50% for group exposure except in the case of specified infrastructure projects. Similarly,

concentration ratios would need to be indicated, even if not specifically prescribed, in

respect of any bank’s exposure to any particular industrial sector so that in the event of

cyclical or other changes in the industrial situation, banks have an element of protection

from over exposure in that sector. Prudential norms would also need to be set by way of

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prescription of exposure limits to sectors particularly sensitive to asset price fluctuations

such as stock markets and real estate. As it happens, Indian banks do not have much

exposure to the real estate sector in the form of lending for property development as

distinct from making housing loans. The example of banks in East and South East Asia

which had over extended themselves to these two sectors has only confirmed the need for

circumspection in this regard. We would leave the precise stipulation of these limits and,

if necessary, loan to collateral value ratios to the authorities concerned. The

implementation of these exposure limits would need to be carefully monitored to see that

they are effectively implemented and not circumvented, as has sometimes happened

abroad, in a variety of ways. Another salutary prescription would be to require full

disclosure of connected lending and lending to sensitive sectors.

Action Taken -As the Committee has noted, Section 20 of the Banking Regulation Act, 1949

prohibits banks from entering into any commitment for granting of any loan or advance to or on

behalf of any of its directors, any firm in which any of its directors is interested as partner,

manager, employee or guarantor or any company of which any of the directors of the banking

company is a director, managing agent, manager, employee, or guarantor or in which he holds

substantial interest or, any individual in respect of whom any of its directors is a partner or

guarantor. The RBI has, as noted by the Committee, laid down prudential ceilings on exposures

to single / group of borrowers. Banks on their own, have also prescribed exposure ceilings on

single borrower and group of borrowers. As regards the recommendation that prudential norms

be set by way of prescription of exposure limits to sensitive sectors, i.e. those sectors where asset

prices are subject to fluctuations, RBI has already put in place a cap on a bank’s exposure to

share market. The banks on their own have limited their exposure to real estate business. Banks

are expected to set norms for lending to any particular industrial sector in their lending policy.

Banks have been advised to disclose in ‘Notes on Account’ to their balance sheets, lending to

sensitive sectors, (i.e., advances to sectors such as, capital market, real estate, etc.) and such

other sectors to be defined as ‘sensitive’ by RBI from time to time with effect from the year

ended March 31, 2000.

The Committee recommends that the RBI should totally withdraw from the primary

market in 91 days Treasury Bills; the RBI could, of course, have a presence in the

secondary market for 91 days Treasury Bills. If the 91 days Treasury bill rate reflects

money market conditions, the money and securities market would develop an integral

link. ….The Committee also recommends that foreign institutional investors should be

given access to the Treasury bill market.

Action Taken -The withdrawal of RBI from the primary market in 91 day Treasury Bills is the

long term objective. The pace of implementation of the recommendation should depend upon the

development and depth of the Govt. securities market. One of the objectives of evolving the

system of Primary Dealers is to improve the underwriting and market making capabilities in

Government securities market so that RBI could eventually withdraw from primary

subscriptions. This will be possible only when Primary Dealers are capable of taking

devolvement, if any, to the full extent.

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3.5 RAGURAM RAJAN COMMITTEE RECOMMENDATION ANALYSIS:

Macro Economic Framework

India’s economy has become more open and it is impossible to control capital flows in

either direction, except for the very short term. Given this, the real exchange rate, which

is the key factor determining India’s competitiveness, is influenced by factors such as

productivity growth and demand supply imbalances that are not changed by central bank

intervention against the dollar. The RBI should formally have a single objective, to stay

close to a low inflation number, or within a range, in the medium term, and move steadily

to a single instrument, the short-term interest rate (repo and reverse repo) to achieve it.

Steadily open up investment in the rupee corporate and government bond markets to

foreign investors after a clear monetary policy framework is in place. India should accept

the possible costs of subsequent currency appreciation as a legitimate down payment on

the more robust markets and financing we will enjoy in the future. We should also relieve

pressure from inflows by becoming more liberal on outflows, especially in forms that can

be controlled if foreign currency becomes scarce. For instance, we should encourage

greater outward investment by provident funds and insurance companies when inflows

are high.

Broadening Access to Finance

Allow more entry to private well-governed deposit-taking small finance banks offsetting

their higher risk from being geographically focused by requiring higher capital adequacy

norms, a strict prohibition on related party transactions, and lower allowable

concentration norms. The small finance bank proposed emulates the Local Area Bank

initiative by the RBI that was prematurely terminated, though the details of the

Committee’s proposal differs somewhat. The intent is to bring local knowledge to bear on

the products that are needed locally, and to have the locus of decision making close to the

banker who is in touch with the client. This would suggest rethinking the entire

cooperative bank structure, and moving more to the model practiced elsewhere in the

world, where members have their funds at stake and exercise control, debtors do not have

disproportionate power, and government refinance gives way to refinancing by the

market. The Committee would suggest implementation of a strong prompt corrective

action regime so that unviable cooperatives are closed, and would recommend that well-

run cooperatives with a good track record explore conversion to a small bank license,

with members becoming shareholders.

The second organizational structure the Committee proposes makes it easier for large

financial institutions to ‘bridge the last mile’. Large institutions have the ability to offer

commodity products like savings accounts at low cost, provided the cost of delivery and

customer acquisition is reduced. They should be able to use existing networks like cell-

phone kiosks or kirana shops as business correspondents to deliver products. Liberalize

the banking correspondent regulation so that a wide range of local agents can serve to

extend financial services. Use technology both to reduce costs and to limit fraud and

misrepresentation.

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Offer priority sector loan certificates (PSLC) to all entities that lend to eligible categories

in the priority sector. Allow banks that undershoot their priority sector obligations to buy

the PSLC and submit it towards fulfillment of their target. Any registered lender

(including microfinance institutions, cooperative banks, banking correspondents, etc.)

who has made loans to eligible categories would get ‘Priority Sector Lending

Certificates’ (PSLC) for the amount of these loans. The Committee recommends

liberalizing interest rates while increasing safeguards that prevent exploitation.

Liberalize the interest rate that institutions can charge, ensuring credit reaches the poor,

but require full transparency on the actual effective annualized interest cost of a loan to

the borrower, periodic public disclosure of maximum and average interest rates charged

by the lender to the priority sector, only loans that stay within a margin of local estimated

costs of lending to the poor be eligible for PSLCs. The Committee believes that through a

combination of transparency, incentives, and eventually competition, liberalized interest

rates to the poor can be kept within reasonable limits, and liberalization would enhance,

and improve the sources of, credit to the poor. The Committee suggests that the

government pay more directly for the social obligations it wants banks to undertake (for

example, by reducing priority sector obligations and, over time, paying directly for

PSLCs).

Leveling the Playing Fields

The greatest source of uneven privileges in the banking system stems from ownership.

The public sector banks, accounting for 70 per cent of the system, enjoy benefits but also

suffer constraints, with the latter increasingly dominating, There is little evidence that the

ownership of banks makes any difference to whether they undertake social obligations,

once these are mandated or paid for. So on net, what matters is how an ownership

structure will affect the efficiency with which financial services are delivered. The

majority of this Committee does not see a compelling reason for continuing government

ownership. There are other activities where government attention and resources are more

important. A parallel approach is to undertake reforms that would remove constraints on

the public sector banks, even while retaining government ownership. Intermediate steps

such as reducing the government’s ownership below 50 per cent while retaining its

control (as suggested by the Narasimham Committee). Unfortunately, ideology has

overtaken reasoned debate in this issue. The pragmatic approach, which should appeal to

practical people of all hues, is to experiment, as China does so successfully, and to use

the resulting experience to guide policy. One aspect of the pragmatic approach would be

to sell a few small underperforming public sector banks, possibly through a strategic sale

(with some protections in place for employees), so as to gain experience with the selling

process, and to see whether the outcomes are good enough to pursue the process more

widely.

Create stronger boards for large public sector banks, with more power to outside

shareholders (including possibly a private sector strategic investor), devolving the power

to appoint and compensate top executives to the board.

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After starting the process of strengthening boards, delink the banks from additional

government oversight, including by the Central Vigilance Commission and Parliament,

with the justification that with government-controlled boards governing the banks, a

second layer of oversight is not needed. Further ways to justify reduced government

oversight is to create bank holding companies where the government only has a direct

stake in the holding company. Another is to bring the direct government stake below 50

per cent, perhaps through divestment to other public sector entities or provident funds, so

that the government (broadly defined) has control, but the government (narrowly defined)

cannot be considered the owner.

Be more liberal in allowing takeovers and mergers, including by domestically

incorporated subsidiaries of foreign banks. The commitment to allow foreign banks

subsidiaries to participate in takeovers will substantially increase the pressure on

domestic banks.

A second way to foster growth and competition, but also to strengthen banks, is to de-

license the process of branching immediately. The RBI can retain the right to impose

restrictions on the growth of certain banks for prudential reasons, but this should be the

exception rather than the norm. One objective of branch licensing is to force banks into

under-banked areas in exchange for permission to enter lucrative urban areas. This is

again an obligation that will have to be revisited as competition increases in urban areas,

but it can be explicitly achieved today by instituting a service norm—for every x savings

accounts that are opened in high income neighborhoods, y low-frill accounts have to be

opened in low income neighborhoods. The service provision obligation could become

traded (much as the priority sector norms earlier), with small banks or cooperatives

acquiring certificates for the excess number of accounts they provide and selling them to

deficient banks. The government may provide added incentives by buying certificates,

and should take over this obligation from banks over time.

Allow holding company structures, with a parent holding company owning regulated

subsidiaries. The holding company should be supervised by the Financial Sector

Oversight Agency, with each regulated subsidiary supervised by the appropriate

regulator.

Creating More Efficient and Liquid Markets

The Committee believes that there are substantial efficiencies to be had by consolidating

the regulation of trading under one roof (SEBI)—this will allow scope economies to be

realized, improve liquidity, and increase competition. Moreover, all markets are

interconnected, so fragmenting regulation weakens our ability to regulate.

Encourage the introduction of markets that are currently missing such as exchange traded

interest rate and exchange rate derivatives.

Stop creating investor uncertainty by banning markets. If market manipulation is the

worry, take direct action against those suspected of manipulation. As an example,

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products such as currency futures and commodity options are banned. A market that is

banned can obviously not attain liquidity or efficiency. Equally problematic, a missing

market can hamper the efficiency of other markets also. For instance, the absence of

interest rate futures can hurt the Treasury market. The recent practice of closing down

commodity markets when the price reaches high levels is unfortunate to say the least.

Create the concept of one consolidated membership of an exchange for qualified

investors (instead of the current need to obtain memberships for each product traded).

Consolidated membership should confer the right to trade all the exchange’s products on

a unified trading screen with consolidated margining.

Encourage the setting up of ‘professional’ markets and exchanges with a higher order

size that are restricted to sophisticated investors, where more sophisticated products can

be traded. Some exchanges, clearing corporations, and depositories are close to being

world class as is the clearing, settlement, and depository infrastructure. New entry by

professional exchanges catering to institutional/sophisticated customers could help, as

could greater competition between elements of the infrastructure.

Create a more innovation friendly environment, speeding up the process by which

products are approved by focusing primarily on concerns of systemic risk, fraud, contract

enforcement, transparency and inappropriate sales practices.

Allow greater participation of foreign investors in domestic markets as in Proposal 2.

Increase participation of domestic investors by reducing the extent to which regulators

restrict an institutional investor’s choice of investments. Move gradually instead to a

‘prudent man’ principle where the institutional investor is allowed to exercise judgments

based on what a prudent man might seem to be appropriate investments.

Creating a Growth Friendly Regulatory Environment

Problems with existing financial regulatory and supervisory structure:

First, the pace of innovation is very slow. Products that are proposed to be

introduced in India (though well-established elsewhere in the world) take several

years to get regulatory approval.

Second, excessive regulatory micromanagement leads to a counter-productive

interaction between the regulator and the regulated.

Third, some areas of the financial sector have multiple regulators, while others

that could pose systemic risks have none. Both situations, of unclear

responsibility, and of no responsibility, are dangerous.

Fourth, regulators tend to focus on their narrow area to the exclusion of other

sectors, leading to balkanization even between areas of the financial sector that

naturally belong together. Financial institutions are not able to realize economies

of scope in these areas, leading to inefficiency and slower growth.

70

Finally, regulatory incentive structures lead to excessive caution, which can be

augmented by the paucity of skills among the regulator’s operational staff relative

those of the regulated. Such caution could actually exacerbate risks.

Rewrite financial sector regulation, with only clear objectives and regulatory principles

outlined.

Parliament, through the Finance Ministry, and based on expert opinion as well as the

principles enshrined in legislation, should set a specific remit for each regulator every

five years. Every year, each regulator should report to a standing committee (possibly the

Standing Committee on Finance), explaining in its annual report the progress it has made

on meeting the remit. The interactions should be made public.

Regulatory actions should be subject to appeal to the Financial Sector Appellate Tribunal,

which will be set up along the lines of, and subsume, the Securities Appellate Tribunal.

Supervision of all deposit taking institutions must come under the RBI. Situations where

responsibility is shared, such as with the State Registrar of Cooperative Societies, should

gradually cease. Drawing a lesson from the current crisis in industrial countries, the

Committee recommends that joint responsibility for monetary policy and banking

supervision continue to be with the RBI, and that the RBI play an important role in the

joint supervision of conglomerates and systemically important NBFCs.

The Ministry of Corporate Affairs (MCA) should review accounts of unlisted companies,

while SEBI should review accounts of listed companies.

A Financial Sector Oversight Agency (FSOA) should be set up by statute. The FSOA’s

focus will be both macro-prudential as well as supervisory; the FSOA will develop

periodic assessments of macroeconomic risks, risk concentrations, as well as risk

exposures in the economy; it will monitor the functioning of large, systemically

important, financial conglomerates; anticipating potential risks, it will initiate balanced

supervisory action by the concerned regulators to address those risks; it will address and

defuse inter-regulatory conflicts. The FSOA should be comprised of chiefs of the

regulatory bodies (with a chair, typically the senior-most regulator, appointed from

amongst them by the government), and should also include the Finance Secretary as a

permanent invitee. The FSOA should have a permanent secretariat comprised of staff

including those on deputation from the various regulators.

The Committee recommends setting up a Working Group on Financial Sector Reforms

with the Finance Minister as the Chairman. The main focus of this working group would

be to shepherd financial sector reforms.

The Committee also notes the consumer faces an integrated portfolio of services. It is

increasingly important for the consumer to have a ‘one stop’ source of redress for

complaints, a financial ombudsman. Set up an Office of the Financial Ombudsman

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(OFO), incorporating all such offices in existing regulators, to serve as an interface

between the household and industry.

The Committee recommends strengthening the capacity of the Deposit Insurance and

Credit Guarantee Corporation (DICGC) to both monitor risk and resolve a failing bank,

instilling a more explicit system of prompt corrective action and making deposit

insurance premia more risk-based.

Creating a Robust Infrastructure for Credit

Expedite the process of creating a unique national ID number with biometric

identification. More sources of information, such as payments of rent or of utilities/cell-

phone bills, need to be tapped to build individual records of payment, which can then

open doors to credit and expand access.

The Committee recommends movement from a system where information is shared

primarily amongst institutional credit providers on the basis of reciprocity to a system of

subscription, where information is collected from more sources and a subscriber gets

access to data subject to verification of need to know and authorization to use of the

subscriber by the credit bureau.

On-going efforts to improve land registration and titling—including full cadastral

mapping of land, reconciling various registries, forcing compulsory registration of all

land transactions, computerizing land records, and providing easy remote access to land

records—should be expedited, with the Centre playing a role in facilitating pilots and

sharing experience of best practices.

Restrictions on tenancy should be re-examined so that tenancy can be formalized in

contracts, which can then serve as the basis for borrowing.

The powers of SARFAESI that are currently conferred only on banks, public financial

institutions, and housing finance companies should be extended to all institutional

lenders.

Encourage the entry of more well-capitalized ARCs, including ones with foreign backing.

If India is to have a flourishing corporate debt market, corporate public debt, which is

largely unsecured, needs to have value when a company becomes distressed.

The Committee outlines a number of desirable attributes of a bankruptcy code in the

Indian context, many of which are aligned with the recommendations of the Irani

Committee.

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CHAPTER 4

FINDINGS /

CONCLUSIONS

73

4.1 BASEL III:

The new capital requirements under Basel III would have a positive impact for banks as they

raise the minimum core capital, introduce counter-cyclical measures, and enhance banks’ ability

to conserve core capital in the event of stress through a conservation capital buffer. The liquidity

standard requirements would benefit the Indian banks in managing the pressures on liquidity in a

stress scenario more effectively. However, in case of inconsistent implementation of the new

framework among different countries would lead to international arbitrage thereby resulting in

disruption of global financial stability.

Basel III framework’s impact on the financial system would be significant, as its implementation

would lead to reduced risk of systemic banking crises as the enhanced capital and liquidity

buffers together lead to improved management of probable risks emanating due to counterparty

defaults and or liquidity stress circumstances. The stricter norms on Inter-bank liability limits

would reduce the interdependence of the banks and the reduced interconnectivity among the

banks would save the banks from contagion risk during the times of crises.

There would be a strong impact on the weaker banks leading to their crowding out. As the

conditions deteriorate and the regulatory position gets even more intensive, the weaker banks

would definitely find it very challenging to raise the required capital and funding. Further, this

would affect their business models apart from tilting the banking businesses in favor of large

financial institutions and thereby tilting the competition. In the light of the increased regulatory

oversight on the organizational structure and capital structure of the financial firms (mainly

banks), there would be scenarios where the banks may look towards reorganizing their legal

identity by resorting to mergers & acquisitions and disposals of portfolios, entities, or parts of

entities wherever possible.

It is observed that banking operations might experience a reduced pace in view of the

heightened supervisory vigil on the activities of the banks in terms of ensuring the new capital

standards and the new liquidity ratios– LCR and NSFR.

Impact of BASEL III on Loan Spread

Impact of Basel III on bank loan spreads was estimated using 2 different methodologies viz., the

representative bank approach of Mervin King, 2010 employed for BCBS study and other one

employing the OECD approach. The results of the estimations for bank loan spread for every

increase in capital ratio assuming RWAs unchanged are presented for comparison in below

mentioned table.

74

Comparison of results for estimation of bank loan spread for SCBs

Increase in Capital Ratio

(percentage

points)

Under representative

Bank Model (King 2010)

employed by BCBS

Under

OECD model

approach

Assuming RWAs unchanged

+1 31.40 15.63

+2 45.20 31.26

+3 59.00 46.89

+4 72.80 62.52

+5 86.60 78.15

+6 100.40 93.78 Source: Dr. Swamy “Basel III: Implication on Indian Banking”

The results of the estimations for bank loan spread for every increase in capital ratio assuming

for decline in RWAs are presented for comparison in below mentioned table.

Comparison of results for estimation of bank loan spread for SCBs

Increase in Capital Ratio

(percentage

points)

Under representative

Bank Model (King 2010)

employed by BCBS

Under

OECD model

approach

Assuming for decline in RWAs

+1 22.00 15.01

+2 31.00 30.02

+3 41.00 45.03

+4 50.00 60.04

+5 59.00 75.05

+6 68.00 90.06 Source: Dr. Swamy “Basel III: Implication on Indian Banking”

The study also offers a comparison of the bank lending spreads for different countries estimated

under the OECD approach in below mentioned table.

Increase in bank lending spreads for a one percentage point increase in bank capital

PARTICULARS USA EUROPE JAPAN INDIA

Bank Lending

Spreads (Basis

Points)

20.05 14.30 8.40 15.63

Source – OECD

The estimation for increase in bank lending spread is found to be comparatively greater in the

United States (mainly due to a higher return on equity and a higher share of risk-weighted assets

75

in bank balance sheets) and lower in Japan (mostly due to a lower return on equity and a higher

share of lending assets in bank balance sheets).

Capital Requirements of Indian Banks

This study has estimated the approximations of additional capital requirements of Indian banks

in the wake of the new Basel III regime in the Indian context. This would enable the banks to

plan their capital raising activity in tune with regulatory requirements. The important assumption

made in the estimation process was that RWAs of these banks would grow by 10 percentage

points annually in Scenario-1 and 12% per annum in Scenario-2 and 15% in Scenario-3.

This increase in RWAs is considered because of the reasoning that the banks grow their loan

book size approximately in the range of 20-25% and also considering the past trend of RWAs.

The estimates of this study are compared with that of other comparable studies by reputed

professional research houses in India.

Summary of findings of different studies on capital requirement of Indian banks

Research House Estimations

Swamy (2012) Study

Swamy (2012) study (this A particular study) estimates that with an

assumed growth of RWAs at 10%, Indian banks would require

additional minimum tier-1 capital of INR 2,51,106.57 Crores. With

RWAs growth at 12% and 15%, the requirement would be in the

order of INR 3,36,390.41 Crores and INR 4,74,168.60 Crores

respectively.

Ernst & Young study

Ernst & Young study anticipates that by 2019, the Indian banking

system is projected to require additional capital of INR 4,31,517

crores of which 70% will be required in the form of common

equity.

ICRA Study ICRA study pegs this figure at INR 6,00,000 crores of which 70-

75% will be the requirement of public sector banks.

PWC study PWC study estimates that Indian banks would have to raise Rs.

600,000 crore in external capital over next 8-9 years, out of which

70%-75% would be required for the public sector banks and rest for

the private sector banks. Further, the study observed that one

percentage point rise in bank’s actual ratio of tangible common

equity to risk-weighted assets (CAR) could lead to a 0.20 per cent

drop in GDP.

Fitch

Ratings

Fitch estimates the additional capital requirements at about INR 2.5

lakh crores to 2.75 lakh crores for Indian banks

Macquarie Indian banks would have to go on a massive capital raising to the

extent of over USD 30 billion (INR 1.67 lakh crores) over the next

five years to cater to their growth requirements and Basel-III

implementation charges

CRISIL

Indian banks may have to raise a total of about Rs 2.4 trillion to

meet growth needs in compliance with the Reserve Bank of India’s

final guidelines on capital adequacy requirements under the new

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Basel III norms by March 2018. Source: Dr. Swamy “Basel III: Implication on Indian Banking”

Cost Benefit Analysis of BASEL III for Indian Banking

It is believed that higher capital requirements under Basel III would prevent possible systemic

crisis and benefit the economy. With this argument in the backdrop, I thought it wise to estimate

the cost of crisis in terms of output loss in GDP in order to facilitate a cost-benefit analysis of the

higher capital requirements under Basel III. Accordingly, I have translated the probability of a

crisis into expected losses in the GDP level in the Indian context based on the internationally

acknowledged assumptions for analysis.

The output loss (compared to the pre-crisis level) for different values of discount factors are

estimated in terms of loss of GDP (at factor costs) in constant prices, With value at 0.025, the

cumulative loss-in-output due to the crisis would be INR 16,01,971 crores for a period of ten

years. Similarly, for values at 0.03, 0.04, 0.05, 0.06 and 0.07 the respective cumulative loss-in-

output are estimated at INR 16,46,065 crores, INR 17,31,568 crores, INR 18,13,581 crores, INR

18,92,213 crores and INR 19,67,570 crores.

Cost Benefit Analysis of BASEL III for Indian Banking

In INR Crores

Estimation Highlights Cost Benefits

Cost estimated as additional

minimum tier-1 capital with

RWAs assumed at 10%.

2,51,106.57

---

Prevention of loss-in- output

due to a crisis with value at

0.025

--- 16,01,971.00

Cost estimated as additional

minimum tier-1 capital with

RWAs assumed at 12%.

3,36,390.41

---

Prevention of loss-in- output

due to a crisis with value at

0.025

--- 16,01,971.00

Cost estimated as additional

minimum tier-1 capital with

RWAs assumed at 15%.

4,74,168.60

---

Prevention of loss-in- output

due to a crisis with a value at

0.025

--- 16,01,971.00

Source: Dr. Swamy “Basel III: Implication on Indian Banking”

Though Basel III implementation is entailed undoubtedly with some costs, the significance of

Basel III should be seen in context of reducing the probability of banking crises at affordable

costs and aiding for a sound financial system.

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BASEL III Timeline – How it is Effective:

The timeline proposed under Basel-III has widely pleased the proponents of stricter standards

though the standards are relatively aggressive and make for safer banks that can better absorb

losses when deep recessions and financial crises suddenly strike. Nevertheless, some critics of

systemically financial institutions are concerned with the ample time permitted for banks to

comply. Nobel Prize-winning economist Joseph Stiglitz is quoted to have opined that delay in

quicker and fuller implementation is exposing the public to continued risk. The argument

sounded by Stiglitz is that banks will continue to pocket their profits instead of pooling the

money as a capital buffer and continue to take big risks as long as possible to collect big bonuses

while they still can make a healthy return on their relatively lower level of capital required.

However, in the Indian context, the timeline for Basel III implementation may not have any

serious impact as the banks are relatively well positioned for smoother implementation of new

capital standards with an exception of some of the public sector banks. The arguments held out

against the timeline in the case of global banks and particularly that of U.S need not hold good in

the case of Indian banks, which are not exposed to volatile and toxic assets. Furthermore, in view

of the increased disclosure norms, banks would be guided by the market forces to increasingly

Basel III compliant well before the suggested timeline by RBI.

In effect, the Basel III timeline offers is a prudent approach by allowing the struggling banks

ample time to ramp up their capital without harming their business, but still compelling them to

make gradual progress towards the desired finish. In the meanwhile, banks that can comply

earlier will likely do so quite ahead of the timeline suggested.

Conclusion of BASEL norm

It needs to be clearly understood that Basel III is an evolution rather than a revolution for many

banks. It is an improvement over the existing Basel II framework; the most significant among the

differences for banks are the introduction of liquidity and leverage ratios, and enhanced

minimum capital requirements. Basel III provides for a timeline of implementation that is quite

acceptable in the case of Indian context as it is observed that Indian banks are relatively well

positioned for smoother implementation of the new standards.

While the effective implementation of Basel III will demonstrate to the stakeholders that the

bank is quite well positioned, a speedy implementation will lead to contribute to bank’s

competitiveness by delivering better management insight into the business, enabling it to take

strategic advantage of future opportunities.

One of the main significant challenges posed by Basel III apart from the increased capital

standards is that of creating a new risk management culture with a greater rigor and

accountability. In effect, Basel III is changing the way the banks look at their risk management

functions and might imply them to go for a robust risk management framework to ensure a true

enterprise risk management. From the regulator’s angle, it requires RBI to be more proactive,

and stricter in terms of regulatory supervision surveillance.

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In order to achieve better risk management and to comply with the revised regulatory reporting

requirements, the risk management teams would require quick and speedy access to quality data

that is clean and accurate. This would call for proper data flow and management systems in tune

with the evolving risk management practices. Effective data management systems are not going

to be cheap as they involve significant costs in their acquisition, up gradation and maintenance.

As Basel III aims at providing a solid foundation for financially sound banking, it is both a

challenge and an opportunity for Indian banks. The opportunity comes in the form of acquiring

new quality capital, selection of technology architecture and redesigning of the risk management

framework for effective risk management as well as risk reporting. The challenge is for the bank

managements and the regulator in successfully implementing the new standards as per the

suggested timeline and win over the stakeholders.

4.2 NARSIMHAM COMMITTEE:

An asset can be classified as doubtful if it is in the substandard category for 18 months in

the first instance and eventually for 12 months and loss if it has been so identified but not

written off.

The Committee has noted that Non-Performing Assets (NPAs) figures do not include

advances covered by Government guarantees which have turned sticky and which in the

absence of such guarantees would have been classified as NPAs. The Committee is of the

view that for the purposes of evaluating the quality of asset portfolio such advances

should be treated as NPAs.

Banks and financial institutions should avoid the practice of “ever greening” by making

fresh advances to their troubled constituents only with a view to settling interest dues and

avoiding classification of the loans in question as NPAs.

The Committee believes that the objective should be to reduce the average level of net

NPAs for all banks to below 5% by the year 2000 and to 3% by 2002. For those banks

with an international presence the minimum objective should be to reduce gross NPAs to

5% and 3% by the year 2000 and 2002, respectively, and net NPAs to 3% and 0% by

these dates.

For banks with a high NPA portfolio, the Committee suggests consideration of two

alternative approaches, in the first approach, all loan assets in the doubtful and loss

categories – which in any case represent bulk of the hard core NPAs in most banks,

should be identified and their realizable value determined. These assets could be

transferred to an Asset Reconstruction Company (ARC) which would issue to the banks

NPA Swap Bonds representing the realizable value of the assets transferred. An

alternative approach could be to enable the banks in difficulty to issue bonds which could

form part of Tier II capital. This will help the banks to bolster capital adequacy which has

been eroded because of the provisioning requirements for NPAs. As the banks in

difficulty may find it difficult to attract subscribers to bonds, the government will need to

guarantee these instruments which would then make them eligible for SLR investments.

79

Priority Sector Lending: The Committee has noted the reasons why the Government

could not accept the recommendation for reducing the scope of directed credit under

priority sector from 40% to 10%. The Committee recommends that the interest subsidy

element in credit for the priority sector should be totally eliminated and even interest

rates on loans under Rs.2 lakh should be deregulated. The Committee believes that it is

the timely and adequate availability of credit rather than its cost which is material for the

intended beneficiaries.

Recruitment: The Committee notes that public sector banks and financial institutions

have yet to introduce a system of recruiting skilled manpower from the open market. The

Committee believes that this delay has had an impact on the competency levels of public

sector banks. The Committee on the Financial System (CFS), 1991 had recommended

that there was no need for continuing with the Banking Service Recruitment Boards

insofar as recruitment of officers was concerned. This Committee, upon examination of

the issue, reaffirms that recommendation.

Structural Issues: In India also banks and Development Finance Institutions (DFIs) are

moving closer to each other in the scope of their activities. The Committee is of the view

that with such convergence of activities between banks and DFIs, the DFIs should, over a

period of time, convert themselves to banks. There would then be only two forms of

intermediaries, viz. banking companies and non-banking finance companies. If a DFI

does not acquire a banking license within a stipulated time it would be categorized as a

non-banking finance company.

The Committee is of the view that foreign banks may be allowed to set up subsidiaries or

joint ventures in India. Such subsidiaries or joint ventures should be treated on par with

other private banks

Though cooperation is a state subject, since Urban Cooperative Banks (UCBs) are

primarily credit institutions meant to be run on commercial lines, the Committee

recommends that this duality in control should be eliminated. It should be primarily the

task of the Board for Financial Supervision to set up regulatory standards for Urban

Cooperative banks and ensure compliance with these standards through the

instrumentality of supervision.

Rural and Small Industrial Credit: The Committee recommends that a distinction be made

between NPAs arising out of client specific and institution specific reasons and general

(agro-climatic and environmental issues) factors. While there should be no concession in

treatment of NPAs arising from client specific reasons, any decision to declare a

particular crop or product or a particular region to be distress hit should be taken purely

on techno-economic consideration by a technical body like NABARD.

As a measure of improving the efficiency and imparting a measure of flexibility the

committee recommends consideration of the debt securitization concept within the

priority sector. This could enable banks, which are not able to reach the priority sector

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target to purchase the debt from the institutions, which are able to lend beyond their

mandated percentage.

Banking policy should facilitate the evolution and growth of micro credit institutions

including LABs which focus on agriculture, tiny and small scale industries promoted by

NGOs for meeting the banking needs of the poor. Third-tier banks should be promoted

and strengthened to be autonomous, vibrant, effective and competitive in their operations.

The Committee recommends that an integrated system of regulation and supervision be

put in place to regulate and supervise the activities of banks, financial institutions and

non-banking finance companies (NBFCs). The functions of regulation and supervision

are organically linked and we propose that this agency be renamed as the Board for

Financial Regulation and Supervision (BFRS) to make this combination of functions

explicit.

The Board for Financial Regulation and Supervision (BFRS) should be given statutory

powers and be reconstituted in such a way as to be composed of professionals. At

present, the professional inputs are largely available in an advisory board which acts as a

distinct entity supporting the BFS. Statutory amendment which would give the necessary

powers to the BFRS should develop its own autonomous professional character. The

Committee, taking note of the formation of BFS, recommends that the process of

separating it from the Reserve Bank qua central bank should begin and the Board should

be invested with requisite autonomy and armed with necessary powers. However, with a

view to retain an organic linkage with RBI, the Governor, RBI should be head of the

BFRS.

No further recapitalization of banks: So far, a sum of Rs.20, 000 crore has been expended

for recapitalization and to the extent to which recapitalization has enabled banks to write

off losses, this is the cost which the Exchequer has had to bear for the bad debts of the

banks. Recapitalization is a costly and, in the long run, not a sustainable option.

Recapitalization involves budgetary commitments and could lead to a large measure of

monetization. The Committee urges that no further recapitalization of banks be

undertaken from the Government budget.

At present, the laws stipulate that not less than 51% of the share capital of public sector

banks should be vested with the Government and similarly not less than 55% of the share

capital of the State Bank of India should be held by the Reserve Bank of India. The

current requirement of minimum Government of India/Reserve Bank of India

shareholding is likely to become a constraint for raising additional capital from the

market by some of the better placed banks unless Government also decides to provide

necessary budgetary resources to proportionately subscribe to the additional equity,

including the necessary premium on the share price, so as to retain its minimum

stipulated shareholding. The Committee believes that these minimum stipulations should

be reviewed. It suggests that the minimum shareholding by Government/RBI in the

equity of nationalized banks and SBI should be brought down to 33%.

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The Reserve Bank as a regulator of the monetary system should not be also the owner of

a bank in view of the potential for possible conflict of interest. It would be necessary for

the Government/RBI to divest their stake in these nationalized banks and in the State

Bank of India.

The Committee strongly urges that there should be no recourse to any scheme of debt

waiver in view of its serious and deleterious impact on the culture of credit.

4.3 RAGHURAM RAJAN COMMITTEE:

Based on the analysis in the chapter, the Committee proposes the steps below as a means to

upgrade the policy framework to meet the challenges that lie ahead. The Committee emphasizes

that these recommended reforms should be seen as a package.

Implementing them partially would make the individual reforms far less effective; indeed, the

Committee cautions that implementing the recommendations selectively could in some cases be

counterproductive. For instance, liberalizing external commercial borrowings by corporate

without allowing for greater exchange rate flexibility would increase incentives for borrowing

via foreign currency-denominated debt, which could be risky.

The Committee views proper sequencing of the recommended reforms as important but, rather

than lay out a specific and rigid timeline, prefers to take a more practical approach of indicating

which reforms could be undertaken in the short run (the next 1–2 years) and which ones should

be seen as longer-term objectives (over a 3–5 year horizon).

Monetary Policy

Move towards establishing RBI’s primary objective as the maintenance of low and stable

inflation. Implicit in this objective will be to maintain growth consistent with the

economy’s potential and to ensure financial sector stability. The objective could be

translated quantitatively into a number, a number that can be brought down over time, or

a range that will be achieved over a medium-term horizon (say, two years). This will

have to be done with the full support of the government, which would simultaneously

commit to maintain fiscal discipline (i.e., stick to the FRBM deficit reduction path) and

not hold the central bank accountable for either the level or volatility of the nominal

exchange rate. The inflation objective would initially have to be set on the basis of a

widely-recognized indicator such as the WPI or CPI, notwithstanding the conceptual and

practical problems with targeting these measures of inflation. Measurement issues will

need to be tackled as a priority and, over the initial medium-term horizon, the RBI will

have to be transparent about what its headline objective implies for inflation based on

other price indexes.

The government would make the RBI accountable for the medium-term inflation

objective, with the terms of this accountability initially being laid out in an exchange of

letters between the Government of India and the RBI.

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The RBI should be given full operational independence to achieve the inflation objective.

It would be useful to enshrine this operational independence and the inflation objective in

legislation, but also strengthen it through clarifying public statements on the respective

roles of the RBI and the government.

The RBI would progressively reduce its intervention in the foreign exchange market.

The RBI should make its operational framework clear, and supplement this with more

frequent and concise statements about its assessments of macroeconomic developments,

the balance of risks in the economy, and projections for output growth and inflation.

The RBI’s Monetary Policy Committee should take a more active role in guiding

monetary policy actions. This Committee should meet more regularly; its

recommendations and policy judgments should be made public with minimal delays.

The RBI should develop a model for forecasting inflation and make the details of the

model public. The model will require refinement as techniques and data improve;

feedback from analysts and academics will facilitate this process. It will have to be made

clear (and the public and market participants will quickly learn) that the model is

intended to guide monetary policy decisions but not in a slavish manner or in a manner

that precludes a healthy dose of judgments.

Capital Account

Remove restrictions on outflows by corporate and individuals, There are already few

restrictions on these outflows, but formal removal of controls, easing of procedures and

elimination of the need for permissions, as well as a strong push to encourage outward

flows would send a strong signal that the government is committing to increased financial

integration and the policies that are needed to support it, Easing of restrictions on

vehicles such as mutual funds and domestic fund managers, that individuals could use for

international portfolio diversification, would be an important ancillary reform.

The registration requirements on foreign investors should be simplified. One transparent

approach would be to end the foreign institutional investor (FII) framework for

investment in equities and, instead, allow foreign investors (including NRIs) to have

direct depository accounts. The distinctions between FIIs, NRIs and other investors could

also be eliminated, with the intent being to eliminate any privileges or costs they may

experience with respect to domestic investors.

Remove the ceilings on foreign portfolio investment in all companies, with a narrow

exception for national security considerations—treat foreign investors just like local

shareholders.

Remove restrictions on capital inflows based on end-uses of funds. These do not serve

much purpose anyway, since they are difficult to monitor.

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Remove restrictions on inward FDI, with a narrow exception for national security

considerations.

Liberalize, then eliminate, restrictions on foreign investors’ participation in rupee

denominated debt, including corporate and government debt.

Remove regulations that hinder international diversification by domestic institutional

investors. Insurance companies, as well as government pension and provident funds

should especially be encouraged to diversify their holdings by investing abroad.

Reduce restrictions on borrowing by domestic firms and banks, whether this borrowing

occurs offshore or onshore, in Indian rupees or foreign currencies. For instance, the

ceiling on corporate external commercial borrowing could be steadily raised for the next

few years until eliminated. If there is excess demand during the transitional phase to

removal of restrictions, borrowing rights could be auctioned. Stability concerns raised by

exchange mismatches between bank assets and liabilities should be addressed by

supervisory and prudential measures.

Fiscal Policy

Continue to reduce levels of consolidated government deficit and public debt (ratios to

GDP); resume progress towards targets specified under the Fiscal Responsibility and

Budget Management Bill. Amend the FRBM Act so as to bring the off-balance-sheet

borrowing by the government integrally into calculations of the government budget

deficit and public debt.

Reduce the Statutory Liquidity Ratio to a level consistent with prudential needs; switch to

direct bond financing of new deficits. Similarly, regulators of pension funds and

insurance companies should set regulations on fund portfolio holdings so as to maximize

the welfare of beneficiaries, and not so as to mobilize the purchase of government bonds.

Transition away from providing sops for exporters in response to currency appreciation.

While many of the recent sops are in the process of being removed, it is important to

curtail expectations of similar sops being offered in the future in the event of currency

appreciation.

Other Reforms

Remove the remaining restrictions on the currency futures market in the short term

(prohibitions against foreign institutional investors, against non-resident Indians, against

products other than futures, against underlying trades other than the rupee–US dollar rate,

and against positions greater than US$5 million). Permitting onshore currency derivatives

markets with no restrictions on participation is an important measure that includes

elements of financial market regulation as well as capital account liberalization. These

markets could be developed fairly quickly as the technical infrastructure for trading of

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these derivatives could be built up soon on the backbone of the existing securities trading

infrastructure.

Improve the structure of public debt management to increase depth and transparency of

this market.

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BIBLIOGRAPHY

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