Introduction

The banking section will navigate through all the aspects of the Banking System in
India. It will discuss upon the matters with the birth of the banking concept in the
country to new players adding their names in the industry in coming few years.

The banker of all banks, Reserve Bank of India (RBI), the Indian Banks Association
(IBA) and top 20 banks like IDBI, HSBC, ICICI, ABN AMRO, etc. has been well
defined under three separate heads with one page dedicated to each bank.

However, in the introduction part of the entire banking cosmos, the past has been well
explained under three different heads namely:

 History of Banking in India

 Nationalization of Banks in India
 Scheduled Commercial Banks in India

The first deals with the history part since the dawn of banking system in India.
Government took major step in the 1969 to put the banking sector into systems and it
nationalized 14 private banks in the mentioned year. This has been elaborated in
Nationalization Banks in India. The last but not the least explains about the scheduled
and unscheduled banks in India. Section 42 (6) (a) of RBI Act 1934 lays down the
condition of scheduled commercial banks. The description along with a list of
scheduled commercial banks are given on this page.
 History of Banking in India

Without a sound and effective banking system in India it cannot have a healthy
economy. The banking system of India should not only be hassle free but it should be
able to meet new challenges posed by the technology and any other external and
internal factors.

For the past three decades India's banking system has several outstanding
achievements to its credit. The most striking is its extensive reach. It is no longer
confined to only metropolitans or cosmopolitans in India. In fact, Indian banking
system has reached even to the remote corners of the country. This is one of the main
reasons of India's growth process.

The government's regular policy for Indian bank since 1969 has paid rich dividends
with the nationalization of 14 major private banks of India.

Not long ago, an account holder had to wait for hours at the bank counters for getting
a draft or for withdrawing his own money. Today, he has a choice. Gone are days
when the most efficient bank transferred money from one branch to other in two days.
Now it is simple as instant messaging or dial a pizza. Money have become the order
of the day.

The first bank in India, though conservative, was established in 1786. From 1786 till
today, the journey of Indian Banking System can be segregated into three distinct
phases. They are as mentioned below:

 Early phase from 1786 to 1969 of Indian Banks

 Nationalization of Indian Banks and up to 1991 prior to Indian banking sector
Reforms.
 New phase of Indian Banking System with the advent of Indian Financial &
Banking Sector Reforms after 1991.

To make this write-up more explanatory, I prefix the scenario as Phase I, Phase II and
Phase III.
Phase I

The General Bank of India was set up in the year 1786. Next came Bank of Hindustan
and Bengal Bank. The East India Company established Bank of Bengal (1809), Bank
of Bombay (1840) and Bank of Madras (1843) as independent units and called it
Presidency Banks. These three banks were amalgamated in 1920 and Imperial Bank
of India was established which started as private shareholders banks, mostly
Europeans shareholders.

In 1865 Allahabad Bank was established and first time exclusively by Indians, Punjab
National Bank Ltd. was set up in 1894 with headquarters at Lahore. Between 1906
and 1913, Bank of India, Central Bank of India, Bank of Baroda, Canara Bank, Indian
Bank, and Bank of Mysore were set up. Reserve Bank of India came in 1935.

During the first phase the growth was very slow and banks also experienced periodic
failures between 1913 and 1948. There were approximately 1100 banks, mostly small.
To streamline the functioning and activities of commercial banks, the Government of
India came up with The Banking Companies Act, 1949 which was later changed to
Banking Regulation Act 1949 as per amending Act of 1965 (Act No. 23 of 1965).
Reserve Bank of India was vested with extensive powers for the supervision of
banking in India as the Central Banking Authority.

During those days public has lesser confidence in the banks. As an aftermath deposit
mobilization was slow. Abreast of it the savings bank facility provided by the Postal
department was comparatively safer. Moreover, funds were largely given to traders.

Phase II

Government took major steps in this Indian Banking Sector Reform after
independence. In 1955, it nationalized Imperial Bank of India with extensive banking
facilities on a large scale specially in rural and semi-urban areas. It formed State Bank
of India to act as the principal agent of RBI and to handle banking transactions of the
Union and State Governments all over the country.
Seven banks forming subsidiary of State Bank of India was nationalized in 1960 on
19th July, 1969, major process of nationalization was carried out. It was the effort of
the then Prime Minister of India, Mrs. Indira Gandhi. 14 major commercial banks in
the country was nationalized.

Second phase of nationalization Indian Banking Sector Reform was carried out in
1980 with seven more banks. This step brought 80% of the banking segment in India
under Government ownership.

The following are the steps taken by the Government of India to Regulate Banking
Institutions in the Country:

 1949: Enactment of Banking Regulation Act.

 1955: Nationalization of State Bank of India.
 1959: Nationalisation of SBI subsidiaries.
 1961: Insurance cover extended to deposits.
 1969 : Nationalisation of 14 major banks.
 1971 : Creation of credit guarantee corporation.
 1975 : Creation of regional rural banks.
 1980 : Nationalisation of seven banks with deposits over 200 crore.

After the nationalisation of banks, the branches of the public sector bank India rose to
approximately 800% in deposits and advances took a huge jump by 11,000%.

Banking in the sunshine of Government ownership gave the public implicit faith and
immense confidence about the sustainability of these institutions.

Phase III

This phase has introduced many more products and facilities in the banking sector in
its reforms measure. In 1991, under the chairmanship of M Narasimham, a committee
was set up by his name which worked for the liberalisation of banking practices.

The country is flooded with foreign banks and their ATM stations. Efforts are being
put to give a satisfactory service to customers. Phone banking and net banking is
introduced. The entire system became more convenient and swift. Time is given more
importance than money.The financial system of India has shown a great deal of
resilience. It is sheltered from any crisis triggered by any external macroeconomics
shock as other East Asian Countries suffered. This is all due to a flexible exchange
rate regime, the foreign reserves are high, the capital account is not yet fully
convertible, and banks and their customers have limited foreign exchange exposure.

The Reserve Bank of India (RBI), is the central banking institution of India and
controls the monetary policy of the rupee as well as US$300.21 billion (2010)
of currency reserves. The institution was established on 1 April 1935 during
the British Raj in accordance with the provisions of the Reserve Bank of India Act,
1934. The share capital was divided into shares of Rs. 100 each fully paid which was
entirely owned by private shareholders in the beginning. Reserve Bank of India plays
an important part in the development strategy of the government. It is a member bank
of the Asian Clearing Union. Reserve Bank of India was nationalised in the year
1949. The general superintendence and direction of the Bank is entrusted to Central
Board of Directors of 20 members, the Governor and four Deputy Governors, one
Government official from the Ministry of Finance, ten nominated Directors by the
Government to give representation to important elements in the economic life of the
country, and four nominated Directors by the Central Government to represent the
four local Boards with the headquarters at Mumbai, Kolkata, Chennai and New Delhi.
Local Boards consist of five members each Central Government appointed for a term
of four years to represent territorial and economic interests and the interests of co-
operative and indigenous banks
DEFINATION

As per section 5(b) of the Banking Regulation Act, 1949,” Banking “means the
accepting, for the purpose of lending or Investment, of Deposits of money from the
public, repayable on demand or otherwise, and withdraw-able by cheque, draft and
order or otherwise.

भभभभभभ भभभभभभभ भभभभ

Seal of RBI The RBI headquarters in Mumbai

Mumbai, Maharashtra
Headquarters

Coordinates 18.93337°N 72.836201°ECoordinates: 18.93337°N

72.836201°E

Established 1 April 1935

Governor Duvvuri Subbarao

Central bank of India

Currency Indian Rupee

ISO 4217 Code INR

Reserves US$300.21 billion (2010

Base deposit 7.00%

rate

Website rbi.org.in
HISTORY

1935—1950

The old RBI Building in Mumbai

The central bank was founded in 1935 to respond to economic troubles after the first
world war. The Reserve Bank of India was set up on the recommendations of
the Hilton-Young Commission. The commission submitted its report in the year
1926, though the bank was not set up for another nine years. The Preamble of the
Reserve Bank of India describes the basic functions of the Reserve Bank as to
regulate the issue of bank notes, to keep reserves with a view to securing monetary
stability in India and generally to operate the currency and credit system in the best
interests of the country. The Central Office of the Reserve Bank was initially
established in Kolkata, Bengal, but was permanently moved to Mumbai in 1937.
The Reserve Bank continued to act as the central bank
for Myanmar till Japanese occupation of Burma and later up to April 1947, though
Burma seceded from the Indian Union in 1937. After partition, the Reserve Bank
served as the central bank for Pakistanuntil June 1948 when the State Bank of
Pakistan commenced operations. Though originally set up as a shareholders’ bank,
the RBI has been fully owned by the government of India since its nationalization in
1949
1950—1960
Between 1950 and 1960, the Indian government developed a centrally planned
economic policy and focused on the agricultural sector. The administration
nationalized commercial banks and established, based on the Banking Companies Act,
1949 (later called Banking Regulation Act) a central bank regulation as part of the
RBI. Furthermore, the central bank was ordered to support the economic plan with
loans.
 1960—1969
As a result of bank crashes, the reserve bank was requested to establish and monitor a
deposit insurance system. It should restore the trust in the national bank system and
was initialized on 7 December 1961. The Indian government founded funds to
promote the economy and used the slogan Developing Banking. The Government of
India restructured the national bank market and nationalized a lot of institutes. As a
result, the RBI had to play the central part of control and support of this public
banking sector.

1969—1985
Between 1969 and 1980, the Indian government nationalized 6 more commercial
banks, following 14 major commercial banks being nationalized in 1969(As
mentioned in RBI website). The regulation of the economy and especially the
financial sector was reinforced by the Government of India in the 1970s and
1980s. The central bank became the central player and increased its policies for a lot
of tasks like interests, reserve ratio and visible deposits The measures aimed at better
economic development and had a huge effect on the company policy of the institutes.
The banks lent money in selected sectors, like agri-business and small trade
companies.

The branch was forced to establish two new offices in the country for every newly
established office in a town.The oil crises in 1973 resulted in increasing inflation, and
the RBI restricted monetary policy to reduce the effects.

1985—1991
A lot of committees analysed the Indian economy between 1985 and 1991. Their
results had an effect on the RBI. The Board for Industrial and Financial
Reconstruction, the Indira Gandhi Institute of Development Research and the Security
& Exchange Board of India investigated the national economy as a whole, and the
security and exchange board proposed better methods for more effective markets and
the protection of investor interests. The Indian financial market was a leading
example for so-called "financial repression" (Mackinnon and Shaw). The Discount
and Finance House of India began its operations on the monetary market in April
1988; the National Housing Bank, founded in July 1988, was forced to invest in the
property market and a new financial law improved the versatility of direct deposit by
more security measures and liberalisation.
1991—2000
The national economy came down in July 1991 and the Indian rupee was
devalued The currency lost 18% relative to the US dollar, and the Narsimahmam
Committee advised restructuring the financial sector by a temporal reduced reserve
ratio as well as the statutory liquidity ratio. New guidelines were published in 1993 to
establish a private banking sector. This turning point should reinforce the market and
was often called neo-liberal The central bank deregulated bank interests and some
sectors of the financial market like the trust and property markets. This first phase
was a success and the central government forced a diversity liberalization to diversify
owner structures in 1998.

The National Stock Exchange of India took the trade on in June 1994 and the RBI
allowed nationalized banks in July to interact with the capital market to reinforce their
capital base. The central bank founded a subsidiary company—the Bharatiya Reserve
Bank Note Mudran Limited—in February 1995 to produce banknotes.

Since 2000
The Foreign Exchange Management Act from 1999 came into force in June 2000. It
should improve the foreign exchange market, international investments in India and
transactions. The RBI promoted the development of the financial market in the last
years, allowed online banking in 2001 and established a new payment system in 2004
- 2005 (National Electronic Fund Transfer). The Security Printing & Minting
Corporation of India Ltd., a merger of nine institutions, was founded in 2006 and
produces banknotes and coins.

The national economy's growth rate came down to 5.8% in the last quarter of 2008 –
2009 and the central bank promotes the economic development.
 Chapter 2- research methodology

Autonomy of the reserve bank of India

structure in banking in India

 The central board of directors is the main committee of the central bank. The
Government of India appoints the directors for a four-year team. The board consists of
a governor, and not more than four deputy governors, four directors to represent the
regional board; usually the economic affairs secretary and the financial secretary from
the ministry of finance and 10 other directors from various fields .The Reserve bank
under Raghuram rajan’s Governorship wanted to create a post of a chief operating
officer (COO),in the rank of deputy governor and wanted to re-allocate between the
five of them (four deputy governor and COO).

The bank is headed by the governor, currently Shaktikanta Das . There are four
deputy Governors BP Kanungo, NS Vishwanathan , Viral Acharya and Mahesh

Two of the four deputy governors are traditionally from RBI rank and are selected
from the Bank’s Executive Directors. one is nominated from among the chairpersons
of public sectors bank and the other is an economist. An Indian administrative service
of office can also be appointed as deputy governor of RBI and later as the governor of
RBI as with the case of Y.Venugopal Reddy and Duvvuri Subbarao. Other persons
forming part of the central board of directors of the RBI are Dr.Nachiket Mor, Y C
Deveshwar , Prof Damodar Acharya ,Ajay Tyagi and Anjuly Duggal.

Uma Shankar, chief general manager (CGM) in charge of the Resereve Bank of
india’s financial inclusion and development department has taken over as executive
directors (ED) in the cenral bank.

Sudha Balakrishna , a former vice president at National Securities Depository

Limited, assumed charge as the first chief financial officer (CFO) of the Reserve bank
on 15 May 2018; she was given the rank of an executive directors.
BRANCHES AND SUPPORT BODIES

RBI Headquarter in Mumbai

The Reserve Bank building as

seen from the Chennai
Suburban Railway lines

The RBI has f our regional representations :Nor th in New Delhi,South in

are f ormed by five member s ,appoi nted f or four years by the central
 government and with the advice of the central board of director s serve
as a f orum f or regional banks and to deal with delegated t asks from
the Central Board..
It has two trai ning colleges f or i t s o f f i c e r
viz. Reser ve Bank Staf f College,C hennai and Collegeof
Agri culturalBanki ng,Pune.There arethreeautonomous institutions
run by RBI namely National Institute of Bank Management (NIBM),
IndiraG andhi Institute of Development Research (IGIDR), Institute
f or

Developme nt and Research in Banking Technology (IDRBT).There

are also f our Zonal Training Centers at Mumbai,Chennai , Kolkata
and New Delhi.

The Board of Financial Supervision (BFS),

F ormed inNovember 1994,serves asaCCBD committee to control the

financial institutions. It has f our members ,appoi nted f or two years ,
andt akes measures to strength the roleof statutory auditors inthe
financial sector, external monitor i n g and internal control ling
systems. The Tarapore committee was set up bythe Reserve Bankof India
underthe chairmanshipoff ormer RBIdeputygovernor S.S.Tarapore to
" llay the road map" to c apital account convertibility . The five-member
committee recommended a three-year time f rame f or complete
converti bility by 1999- 2000

On 8 December 201 7,Surekha Marandi, Executive Director (ED) of

Reserve Bank of India,said RBI will open an office inthe north-eastern
state of Arunachal Pradesh

FUNCTION OF RBI
 Reserve Bank of India
regional office, Delhi
entrance with the Yak shini
scul pture depicting
"Prosperity through
agriculture".

The regional office of RBI

(right) in front of
GPO (left) at Dalhousie Square, Kolkata .
 The central bank of any country executes many f unctions such as ove
rseei ng monetary policy, issui ng currency,managi ng forei gn
exchange,worki ng as a bankf or govern ment and a s a banker of
schedul ed commercial banks. It also works f or overall economi c
growth of the country.The preamble of the Reser ve Bank of India
descri bes its main f unctions as:

t.o regulate the issue of bank Notes and

akeepin greserves with a view to securing
monetary stability inInd ia andgenerally to
operate the currency and credit ssystem of the
co untry to its ad va ntage.

 FINANCIAL SUPERVISION

The primary objecti ve of RBI isto under take consoli dated

supervi sion of the financial sector comprising commercial
•
banks financial institutions and non-banking finance companies.

The Board is constituted by co-opting f our Directors from the Central

Board as members f or a term of two year s and is chai red bythe
governor .Thedeputy governorsof the reserve
bank are ex-officio members. One deputy governor,usually, the
deput y governor in charge of banking regulation and supervisi on,
is nominated as the vice-chairman of the board .The Board is required
to meet normally once every month .it inspection reports and other
supervisory issues placed before it by the supervi sory departments.
BFS through the Audit Sub-Committee also aims at upgradi ng the
quality of the statutory audit and inter nal audit f unctions in banks
and financial institutions. The audit sub- committee includes
deputy governor as the chairman and two Directors of the Central
Boardas members.The BFS over seesthe f unctioni ngofDepartmentof
Banking

Supervision (DBS),Department of Non- BankingSuper vision (D NBS)

and Financial
Institutions Division (FID) and gives directions on the regulatory and
supervisory issues.
 Regulator and supervisor of the financial system

The institution is also the regulator and super visor of the financial
system and prescri bes broad parameter s of banking operati ons
withi n whi ch the country's banking and financialsystem functi ons. Its
objectives areto maintain public Confidenc
In the system ,protectdepositor s'interestand providecost-
effectivebankingservicestothe public.TheBankingOmbudsman
Schemehas beenform ulatedbytheReserveBankofIndia (RBI)f or
effectiveaddressi ngofcomplaints by bank customers. The RBI
controls the monet ary supply,monitors economic indicator s like
the gross domesti c product and has to decide the design of the
rupee banknotes a s well as coins.

 RegulatorandSupervisorofthe PaymentandSettle ment Systems

Payment and settlement systems play an important role in

improving overal l economi c efficiency.The Payment and
Settlement Systems Act of 2007 (PSS Act ) gives the

Reser ve Bank over sight authority,includi ng regulationand

supervi sion, f orthepayment and settlement systems inthe
 country .Inthis role,theRBIf ocusesonthedevelopmentand
f unctioni ngof safe,secure and efficient payment and settlement
mechanisms. Two payment systems National Electronic Fund
Transfer (NEFT)and RealTimeGross Settlement (RTGS) allow
individuals, compani es and firms to transfer f unds f rom one
bank to another .These f acilities can only be used f or transferri ng
money withi n the country .

NEFToperatesonadeferrednetsettlement (DNS)basisandsettles
transacti onsin batches.Thesettlementtakesplacef orall transactions
received tilla particular cut-off time.Itoperates inhour lybatches -
there are 12settlements from 8 am to 7 pm on
Weekdays and SIX between 8 am and 1 pm on Saturdays. Any
transacti on initiated after the designated time would have to wait till
the next settlement time. In RTGS,transactions
Are processedcontinuously, allthroughthe businesshour s.RB l's
settlementtimeis9am to 4 :30 pmon weekdays and 9 amto 2:00 pm on
Saturday .

 BankerandDebtManagerto Government

Just like individuals need a bank to carry out their financial

transacti ons effectively & efficiently,Government s also need a bank
to carry out thei r financial transacti ons. RBI serves this pur pose
for the Government of India (Gol).A s a banker to the Gol,RBI
maintains its accounts ,receive payments into and make payment s
out of these accounts. RBI also helps Gol to raise money f rom
public via issui ng bonds and government appr oved securities.

 Managing fore ign exchange

The central bank manages to reach dif ferent goal s of the

Foreign Exchange Management Act 1999.Thei r objective is to
faci lit ate external trade and payment and promote orderly
development and maintenance of f oreign exchange market in
India. With increasi ng integrati on of the Indian economy with
the global economy arising from greater trade and c apital
flows, the f oreign exchange market has evolved as a key
segment of the Indian financial market and RBI has an
important role to play in regulating & managi ng this segment.
RBI manages f orex and gold reserves of the nation .On a given
day, the f oreign exchange rate reflects the demand f or and
supply of f oreign exchange arising from trade and capital
transactions. The RBl's Financial Markets Department (FMD)
participates in the f oreign exchangemarketbyundert aki ng
sales/purchases of foreign currency to ease volatility in
periods of excess demand for /supply of foreign currency.

 Issue of currency

Reser ve bankof India isthe solebodywho is authorizedto issue

currencyinIndia.The bankalsodestroysthesamewhentheyare notfit
for circulation .All the money issued by the central bank is its
monet ary liability,i.e., the central bank is obl igedto backthe currency
witha ssetsof equalvalue ,to enhancepublicconfidenceinpaper
cur rency. Theobjectives aretoissue banknotesand give public
adequate supply ofthe same,to maintainthecurrency andcredit
system of the country to utilize it is its best advantage, and to
maintain the reserve. RBI maintain the economic structure of the
country so that it can achieve the objective of price stability as
wellas economics development because both objectives are
diverse in themselves. For printing of notes , the Security Printing
and MintingCorporation of India Limited (SPMCIL), a wholly
owned company of the Government of india ,has set up printing
presses at Nashik, Maharashtra and Dewas, Madhya Pradesh .The
Bharatiya ReserveBank Note Mudran Private Limited (BRBNM PL),
also has set up printing presses in Mysore in Karnataka and Salboni
inWest Bengal .Inall, there are f our printing presses. And f or the
minting of coins,SPMCIL has f our mint s at Mumbai, Noida (UP),
Kolkata and Hyderabad for coinproduction.Whi le coins and one
r upee notes are minted by G overnment of India (Gol),the RBI
works as an agent of Gol f or distr ibuting and handling of coins.
RBI also works to prevent counterfeiting of currency by regularly
upgradi ng security features of currency . For printing currency, RBI
has four f aci lities at Dewas,Nasik,Mysore and Salboni. The RBI is
authorized to issue notes up to val ue of Rupees ten thousands and
coin up to one thousand .New notes of Rupees 500 and 2000 have
been issued on 8 November 2016. The old series note Rupees 1000
and 500 are considered illegnal and just paper from midnight on 8
November 2016. Earlier 1000 notes have been discarded by RBI.

 Banker's bank

Nagpur branch
holds

most of India's gold deposits

Reser ve Bank of India also works as a central bank where commerci al

banks are account holder s and can deposit money. RBI maintains
banking account sofallschedul edbanks. Commerci al banks create
credit. It is the duty of the RBI to control the credit through the CRR,
bank rate and open market operati ons. A banker's bank , the RBI
f acilitates the cleari ng of cheques between the commercial banks
and helps the inter-ban k transfer of f unds. It cangrant financial
accommodati on to schedule banks. It acts as the lender of the last
resort by providing emergency advances.

 RegulatoroftheBanking System

RBI hasthe responsibility of regulati ngthe nation'sfinancialsystem .

A s a regulator and super visor of the Indian banking system it
ensures financial stabi lity & public confidence inthe bankingsystem .
RBI uses methods like On-site inspections, off-site survei llance,
scruti ny & periodic meetingsto supervi se new bank licenses
, setti ng c apital requirements and regulating interest rates inspecific
areas. RBI is currently f ocused on implementing Basel norms.

 Detectionoffakecurrency
In order to curb the fake currency problem, RBIhas launched a
websi teto raise awareness among masses about f ake notes inthe
market.w w w.paisaboltahai.rbi.org.in provides information about
identifying f ake currency . On22January2014;RBIgaveapress
release stating that a fter 31 March 2014,it wi ll completely
withdra w from circulation of all banknotes issued priorto 200 5.
From 1A pr il 2014,the public will be required to approach banks
f or exchangi ngthese notes.Bankswi ll provide exchange f acility
f or these notes until f urthercommuni cation.The reserve bank has
also clarified that the notes issued before 200 5 wi llconti nue to be
legal tender .This would meanthat banks are requiredto exchange
the notes for thei rcustomers as well as f or non-customers. From 1
July 2014, however,to exchange morethan 15pieces of '500 and
'1000 notes,non-customers wi ll have to f urnish proof of identity and
residence a s well as show aadhar to the bank branch in whi ch she/he
wants to exchange the notes.
This movef romthe reserve bank isexpected to unearth black money
held incash .A s the newcurrency noteshaveaddedsecurity
f eatures,they woul d help in curbi ngthe menace of f ake currency .l

 Developmenta l role

The central bank has to perform a wide range of promotional functi ons
to support national objectivesandindustries. TheRBIf acesa lot of inter-
sectoral and local inflation-related problems. Some ofthese problems are
results ofthedomi nant partofthe publicsector .

Key tools in this eff ort include Pr iority Sector Lending such
as agriculture, micro and small enterprises (MSE), housi ng
and educ ation .RBI work towards strengtheni ng and
supporti ng small local banks and encou rage banks to open
branches in rural areas to include large section of society in
banking net.
 Related functions

The RBI is also a banker to the govern ment and per f orms merchant
banking functi on f or the central and the state governments. It also
acts as their banker.The National HousingBank (NHB) was
est ablished in 1988to promote private real est ate acquisition.The
institution maintains banking accounts of all schedul ed
banks,too. RBI on 7 August 20 12 said that Indian banking
system is resilient enough to f ace the stress c aused by the
drought -like situation because of poor monsoonthisyear .

 Custodian to foreign exchange

The Reserve Bankhascustody ofthe country's reserves of

internationalcurrency, andthisenablesthe Reserve Banktodeal with
crisis connected with adver se balance of payment s position .
 Chapter 3 data analysis

EMERGING CHALLENGES OF RBI

Not surprisingly. the reforms have been a mixed

bag. \Vhile there have no doubl been some successes in the
aftermath of the reforms. they have not been without their
pitfalls .The obvious question that therefore nrises is: what nre
the emerging chal lengesand how can they be tackled?
It is i mportan t in this context to note thaL given the size or
the financial system broadly defined. the question of banking
soundness cannot be analyzed in isolation of the broader
system (CrockctL 1997). This is because financial
disturbances. wherever they originate. can have serious
consequences for the real economy. This is also a logical
consequence or \V alras law.which states that disequilibrium
in one particular market must imply an out of equilibrium
position in at least one other markeL And importantly. special
attention needs 10 be paid 10 banks. especially in emerging
economics".Although they might be declining in overall
importance when measured by the volume of transactions
Or the rclati\•C scale of financial intermediation, they remain
or strategic importance, notwithstanding the importance or
other major entities in the financial system, viz., development
financial institutions and NBFCs. It is in this context that a
thorough analysis of the challenges facing Indian banks
istaken up.The PSBs in India have strategically been the
engines of growth, not only for economic activity, but also for
the financial sector through its var ious para-banking channels
like mutual funds, merchant banking, housing finance, and the
like. Not surpri singly, PSBs have been historically viewed
as instruments of delivery of Government policies, and
consequently, a large quantum of economic and social
investment bas been dovetailed into them. As a consequence,
it isof no surprise that any constructive dialogue on the status
of financial sector reform in India will perforce need to focus
predominantly on the banking segment, with an emphasis on
public sector banks, in particular.

1 . Structure of the Financial System: Pre-liberalisation, the

Indian banking system was protected from the vagaries of
business cycle by high levels of statutory pre-emptions and a
contr0l over flow or credit. Additionally, the lending portfo lios
of banks also included exposures on account of financing for
food procuremen t operations and debts guaranteed by the
sovereign or sub-sovereign. \Vhile this bad the effect of generating
guaranteed profitability, it also made the system highly
fragile"'. \Vhile that might not be the case at present, given the
comfortable capital adequacy or PSBsn alongside reduction in
NPAs, it clearly brings out the fragility of the Indian banking
system. aearly, with a greater quantum or resources for lending
purposes. banks would need 10 be pro-active in management
or their as. et ponfolio a. opposed to liabilities alone in order to
withstand pressure on their bottom line. Although the PSBs
dominate the banking sector, increased competition
has reduced their dominance some what since linnncial
liberalization wa. initiated. Competition has come from
various qu arters:developmen t fi nancial institutions (DFl.s). the
capital market. NBFCs. foreign banks and the new private sect or
banks. DFls have increased their shares or financial assets in the
early 1990s. but their growth has since slowed down and for
several or them. their assets have deteriorated and they arc
restru ctu ring in order to re-position themselvesin the new financial
market place.Both the NBFCs and the capi tal market grew rapidly
after libcralisntion as sources or runding. with the capital market.
in tum. benefiting from liberalised portl'olio inflows. \Vhile the
role or the NBFC sector has declined somewhat. the importance of
the capital market has. by and large, remained intact.
The issue that arises.therefore. is:what can be said about
the changing focct or PSBs? \Vithin the commercial banking sector.
the new private banks have grown to account for about 4-5 per
cent or commercial bank assets by end-March 2000: the share or
foreign banks has increased by about one percentage point
around 3 per cent. and even the old private sector banks have
increased their share by over a percentage poi nt. Correspondingly.
the share or PSBs has declined to about 80 per cent".The new private
and foreign banks have increased competition for the best clients
and arc eroding the share or PSBs in terms or assets at about I
per cent per annum This has created a chasm between the
relatively technology-sav''Y new private sect or/foreign banks (and
to a certain extent. the better performing PSBs) and the remaining
ones. At the same time.the bank asset to GDP ratio.which was
around 70 per cent at the beginning of the nineties has declined to
about 64 per cent by 1999-2000. Consequently. the competition
among banks is on a shrinking pie. The loss or business by
PSBs. especially the niche clientele might adversely impact their
portfolio and more so at a time.when sub-PLR lending has been
permitted. PSBs would need t o re-position themselves to not only
protect their client base.but also to avoid adverse selection
problems by reckless lending to built upon their credit portfolio.
possibly by adopting an integrated risk management strategy.
encompassing the areas or credit. market and operational risks.
The pressure on bouom line and franchise values (present value
or future economic profits) would need to be taken into account
in the strategy for dealing with the PSBs and their privatisation.
A time has also come for the Government/RB I to
consider whether the financial system is
Optimal' in terms of the number of banks ,or whether there is a case
for rationalization or branch network (along with mergers of few
banks). The existence or a large number of banks in public sector
is widely viewed as a matter of historical accident and a more
rational view on economic considerations would need to be taken.
The PSBs vary greatly in size, branch network. deposit base and
asset qualit y. If these banks are to improve their standards of
service and compete more effectively with their new priVllle and
foreign counterparts, they would need to be more capitali2ed,
automated and technology-oriented, even
while strengthening their internal operations and systems. While
capital levels of these banks have improved, they would need to
be augment ed further to enable them to effectively compete with
their counterparL• abroad, who are much bigger in term• of their
size and asset ba•e. It is in this context that a restructuring of these
banks is deemed as important (NCR-ll, 1998).In the absence of full-
blown reform
in the labour sector, which still suffers from high levels of rigidities,
the suuctural is.•ues could pose a major stumbling block.This point
was also echoed in NCR -11, where it observed that 'if Indian bank.
are to be mad e more comparable with their compet itors from abroad
with regard to the size of their capital and assets base, it would be
necessary to restructu re these bankc•'(pp.48). One isalso witnessing a
degree of mcrgcacquisitions moves among the new private sect or
banks.It appears that the new private sector banks with institutional
pare ntage are making tremendous strides. They are also performing
well in tenn.• of enhancing shareholder value. \Vhile they could be
seen in the not-too-distant future to consolidate their operations
further, it is the PSBs that need to t ake prompt action. In view of
the overlap of operations among PSBs, another aspect of re-sizing
which has gained currency is rationalization and restructuring the
bra nch network of the weak banks in such a fashion that the unviable
rural branches of these banks is tak en over by the Asset
Reconstruction Fund (ARF)/converted to a separate entity.while the
viable urban bra n ches is merged with some of the st.rong ban ks.

2. Capital Adequacy : Imposition of minimum capital adequacy

 requirements promotes more prudent management of commercial
ban ks. A high capital adequacy requirement limits the ability to
extend additional loans and thus con1ains inter-ban k competition.
which would increase the financial cushion of commercial banks to
cope wi th a volati le economic environment (Eichengrccn. 1999)".
Studies reveal that capital has been instrumental in innucncing
bank behaviour in the Indian cont ext. In other words. capi lal
requirements do seem lo affect bank behaviour over and abo\'C the
influence of the banks' own internally generated capital targcis
.More importantly, such adjustments by banks in their capital ratios
arc effected primarily by boosting their capital rather than through
systematic substitution
Away from high-risk loans (Nachnnc ct 111., 2000). However. the capital
levels still slightly
Exceed the volume of net NPAs. On average. TI1e (wcigh1cd)
average capital ratio for PSBs has risen from 8.7 per ccnl of risk
weig hted assets in 1996 to 1 1.2 per ccn1 in 1999. However. With the risk
weight
of Government debt and cash reserves being negligible'°. which
represents roughly 3(}.35 per cent of assets, the volume of capital
is not much larger than net N PAs.
It also needs to be recognized that the prescription of norms is not
sufficient for good banking: 'stress testing' of figures is required
to ensure that the banking system is resilient to ad-erse macro·
economic shocks. In this context, in order to understand the
consequences of an adverse shock to the system and examine how
far the (banking) system is able to withstand such shocks,we
conducted a 'stress test' of a vuln erability to credit risk. We consider
two scenarios (1) where 13 per cent of the loons become non-
per fonning and provisioning is made at I0 per cent, and (2) where
5 per cent of the loons become non-per fonning and provisions are
made at 35 per cent. \Vbile the first case represents an extreme
situation of highest N PA growth witnessed by the PSBs in a
particular year, wherein provisions are made at 10 per cent slipping
into sub-standard category, scenario 2 depictS a situation of the
a,•erage N PA growth of the PSBs over the span of the reforms
process and the average level of provisioning that PSBs
make on N PAs.31 The results reveal that in the first case, capital is
reduced to a quarter of its actual
amount by the 1 1th year (and virtually wiped out by the 20th
year), and in the second case, capital is reduced to zero by the end
of the 6th year. The post-shock time path of capital under the two
scenarios is presented in Exhibit l and the one period post-shock
scenario is presented in Table 10.The immediate effect of the
NPAs is a loss of interest income to the PSBs to the tune of Rs.55
billion (0.6 per cent of a.<sets) un der the first scenario and Rs.2 1
billion (0.2 per cent of a.<sets) under scenario 2. \Ve also find that
the maxi mum additional provision that can support the present
capital adequacy level of 9 per cent is Rs.70 billio n. Ou r analysis
support.< the observat ions by Sheng (1996) who showed that NPA
level of 15 per cent would su ffice to wipe out the net worth of the
banl.ing sector in 15 years.
The capit al of the PSBs ha.< increa<
. ed in three ways:
Government capital injections. equity sales t o the pu blic and
retained earnings, which are relatively small.The Government' s
total injections over Rs.200 billion between 1992-93 and 1998-99.
equivalent to an annual avernge of nearly 0.3 per cent of GDP, has
primarily been in the fonn of non-marke t able Government bonds
paying 10percent. which ha.• added t o t he share of Government
debt in the recipient banks. Excluding the interest income on
recapital isation bonds is likely to substant ially affect the net profits
of PSBs".

In spite of the wide heterogeneity among PSBs in terms of

their product sophistication and cu stomer or ient at ion, t he

present prescription of CRAR is that of ·one-size-fits-all'.
 Gi,..,n their wide divergences, an i mportant aspect for

consideration is whether individual banks could be

encouroged to maintain higher CRAR than Lhe stipulated

minimum. to renect their differential risk profiles". This seems

all the more relevant m a lime when measurement of risk-

weighted a..scis proves problematic. in view of the

deficiencies i n the valuation of collateral. the weaknesses

in legal system which inhibilS prompt recovery and the

i nadequate risk management techniques".The

recommendations contained in the NCR- U of raising the

minimum CRAR to 10 per cent by 2002 with the ( RBl l having

the authority to raise this further i n respect of individual

banks ·;r in itsju dgrr1CJ1t the situation with respect 10 tllcir risk

profile w3mwts such 311 increase&(emphasis added) mcriis

consideration.

3. Bank Recapilalisation: The experience of bank recapitalisation in several parlS

of the world has demonstrated that the exercise of recapitalisation docs not
necessarily prevent banks from rushing into headlong trouble again (Ha wkins
and Turner. 1999). In fact. it often sen-es to distort the incentive structure,
erode discipline and reaffirm the faith of these institutions in the "deep
pockeis · of the Government. Recapitalisation of wcalc banks using public
money is also a cosUy and unsustainable option, in view of the increasing
strains on the Go\'Cmmcnl exchequer. Recent studies (Standard & Poor and
CR!SlL, 1999) have estimated that India's scheduled commercial hanks require
bet\l.'CCn USS! I billion to USS 13 billion in new capital to support losses
embedded in impaired asseis. 11 appears thaL even after allowing for additional
infusion of capital through internal generation and access to sub- ordinated
debt, the gap between the capital required by these hanks and the leeway
available to raise the same from market sources, is likely to remain significant.
The ob\<ious question which merit aucntion is whether the gap should be filled
by the Government or alternately, whether the legislati,•e ceiling for public
subscription should be raised. At a time when the Go,-emmcnt exchequer is
under stress, the former docs not seem to be a viable solution. Recapitalisation of
public sector hanks also docs not seem to be feasible, since it would be tantamount to
monetisation with potentially innationary implications. In this context, the
Government bas indicated that it \l.<ill adopt a gradual privatisation agenda where it
ownership of PSBs will be gradually reduced over a period of time. Such
proposal to dilute equity raises some difficull issues. First, though gradual, it
will necessitate Parliamentary approval for a further change in laws, since the
Banking Companies-Acquisition and Transfer of Undertakings Act, 1969 still
requires the the Governmen t t o hold more than 51 per cent of nntionali<cd bank
equity. Second, the Union Budget 1999· 2000 announced the intention of
the Government to reduce its holdings in PSBs to 33 per cent, while ensuring
that bank. retain their 'public sector character"'. The RBI has bttn of the view
that even if the economy grows at the current rate and capital adequacy non are the
same At present bank (barring the three weak banks) would require Rs.100 billion
over the next five years.Such a move might turn out to be counter-productive. in the
sense that such privatizati on might result in long-term greater cost to the
Government. if. in an eventuality, it is required to support the banks in the future.since
their closure might not be feasible on political-economy grounds as it might cause
unacceptably high level of socio-economic distress 37• In addition. two other issues
merit consideration. The first is the modalities and sources of raisi ng such n large
quantum of resources.owing to the lack of depth and liquidity of the eq uity market.
Second. the performance of some of the lxl.nks which ha,•e divested in so far as their
equity is concerned have not been very encouraging.As it is.net profit exclusive of
income from recapitalisation bonds for nationalised banks has risen 1113J'ginally
from Rs.6.1 billion in 1996-97 to Rs. 6.4 billion in 1999-00.
4. Pro-cycliclty or l'rudential Norms: One or the difficulties of implementing capital
adequacy requirement is that bank behaviour tends to be pro-cyclical. independently
of the regulations in place and the need for such tightening usually becomes manifest
when recession or adverse shocks impinge upon the system, revealing the lacuna in
existing systems (BIS. 2000).During booms.growth and rising asset prices can
disguise fundamental underlying problems .
An important question that arises is whether bank regulations should
be tightened during a recession or a boom. Two contradictory'iews have
enicrged in the literature: on one hand. tightening of the requirement rnay lead
to a curtailment of bank credit. On the other. sustainable growth is unlikely to
resume until confidence in the banking system is restored-especially in
countries with inadequate standards and provision.
The pro-cyclicity of prudential regulations raises an important issue about
adequacy of capital in India. In other words, what could be the appropriate
cyclically adjusted ratio that might mitigate moral hazard behaviour? The
timing and extent of progress in tightening of such regulations would have to
take into account the cyclical factors in the economy. This would require
correct identification of the cycle. Second, adequate notice would need to be
provided t o market participants to enable them to be fully
prepared to meet the changing prescriptions. Finally, intense consultation
process in detailing the prudential regulations would be necessary so
that 'prudential regulations [are] introduced at an
'appropriate' pace, in order to reach the objective of meeting financial
standards as soon as feasible (Reddy, 200 Jc). This needs to be tempered with
an understanding of the fact that while capital levels might provide effective
cushion in an upswing, they might prove to be inadequate in downturns, as
finns find difficulty to service their Joans. Therefore , a< each finn auempts to
!t:ltisfy their capital adequacy standards, the whole system may lind its strategy
completely undermined, eventually resulting in a worsening of capit al adequacy
standards. It i.< therefore necessary to lind out the levels of NPAs at which
confidence in the banking system can be maintained m high le\'els, and, at the
!tame time, the Je,..,J of CRAR needed to sustain the NPA level. The necessity
of raising the minimum CRAR to 10 per cent needs to be viewed in this
light. Two important question.< need to be addressed in this context: whether
the CRAR of I 0 per cent is suflicien t to maintain conlidence in the banking
system, gi\'en the present
levels of NPAs in the PSBs; and. second, first, how far are all the PSBs
capable of reaching the 10 per cent CRAR . As at end-March 2001, a< many as
23 PSBs had reported to have exceeded the CRAR of J O per cent; while the
reported level of gros.< NPAs to t otal as.<ets stood at 5.3 per cent•.As at end-
March 2000, wherein 22 out of 27 banks had CRAR exceeding 10 per cent
and the gros. NPA to total as.<et figures were equal to 5.5 per cent of total

assets. S. Treatment or wea k Banks: A sound banking system by definition

presupposes that all the banks. or at least a majorit y of them within the

system are strong and good as viable concerns. However. every system has its

own instances of weak links and the banking system is no exception . It is.
therefore. desirable to discuss the options available to the weak banks for

ensuring resilience of the system.\Vhile Ihc root cause of a bank lx".Coming

weak can be Iraced to managerial inadequacies. existence of high NPAs is one

of the prominent manifestations. Poor quali1y of assets confronted with

stringent IRAC norms can nnd sometimes docs result in wiping out Ihc entire (or

a substantial) portion of the net worth of n bunk (Sheng, 1996).

It is often argued that the problem of weakness in the banking sector has had its
roots in directed lending on behest of the Govcmmenl, and that the lmtcr has
the responsibility to bail out the weak institutions. One of the proposals to
effect this bailout. without direct recapitalisation. mooted in NCR-I. was U1e
proposal to setting up ARF to take over the bad assets from these troubled nt a
discount. follow- up the loans and effect recove ry. While variants of such
institutional arrangements to tackle the problem of bad loans have been an
integral part of bank resuucturing progrrunmcs. in countries as Spain. Sweden.
Philippines and more recently in Japan. Malaysia and Korea (Sheng.
1996:Hawkins and Turner. 1999). the ARF did not find favour in India for
several reasons (RBL 1992-93).FirsL it was fell that a centralised all-India fund
would be severely handicapped in its recovery efforts by lack of widespread
geographical reach which individual banks possess. Second. there could be a
moral hazard problem. making banks complacent about recovery. Finally,
given the large fiscal deficits facing the Go"ernmcnL there was a problem
financing the ARF. Unfortunately, the legal framework does not exactly
provide an enabling or conducive framework to address thisissue.
Subsequently, the Verma Committee on Restructuring \Veale PSBs formaJiscd
the proposal for an
Such a proposal has raised several crucial issues. First. the institution of ARf is
crucially based on
the presumption that it wou ld be successful in recovering bad debts of the
banking sector where the banks themselves have failed, as otherwise, the
ARf could itself become sick after a period of time! The absence of strong
bankruptcy and foreclosure laws in India are as likely to hamper the
rteO\'ery operations of specialised Asset Management Companies (AMCs) as
they do banks and financial institutions. This contrasts t o the US S&L debacle
where the depth of the markets coupled with their high marketable value could
enable high recoveries, which limited the damages to a great extent. Second, it is
important to note that to the extent there is a gap between what is recovered
and what it will ha\'e to pay to its bondholders, the shortfall for an ARf will
have to be made good by the Government. since the bonds would be
guaranteed by it. An option might be to fix a time frame for the ARf to
achieve its results; otherwise, the Government will not be obliged to bridge
the shortfall. Howe\'er, unless it is assumed that over the period, the weak
banks become strong enough to absorb the transfer of some bad loans, this
might defeat the very purpose of setting up the ARF.Third, while the ARF
migh t effect a·one- time' cleaning of the balance sheet of banks of their non-
performing loans, this does not foreclose the possibility of the bank turning weak
once ngain owing to inadequacies in their business revenue model.

A second proposal on the treatment of weak bank. has been that of narrow
banking (Tarapore,

1 999). This would include restricti ng the incremental resources of these institutions only to
in\'e:stments in
high quality market able securit ies of minimal risk t o completely match the maturity
prolile and liquidity needs of their deposit liabilities...However, the risks i nvolved i n
narrow bankin g arc und errated in this view of the ban king busi ness (Ghosh and Saggar,
1998). One might adduce severa l reasons behind this assen.ion. For one. much as narrow
banking reduces liquidit y and credit risks, it exposes the banks to increased market and
interest rate risks, as the entire asset portfo l io or bank.< co1111>riscs of marketab le
securities. Second. the i mplicit assumption behind narrow bankin g is ll1at Government
securities have rero defau lt risk attached 10 lliem.Tltis proposition is not necessarily bonic ou t
by empirical evidences as instancesof repudiation of sovereign debt (in Mexico and R u ssia)
have not been u ncommon in the history of financial markets.Third, the proposal t o covert a
commerci al bank i nto a nan·ow bank in itself can be detrimental 10 the reputation of the
bank management and the faith of depositors, enhan cing the probabil ity of a run on the i
nstitution.Fourth ,other lliings remaining the same, narrow banking can only tackle the
problem at the increment ; it overlooks the issue of overhan g. \Vhcthcr narrow banking
shou ld not be adapted would l ie i n whether the bal ance of advantages exceeds the
disadvantages. However, narrow banking can best be viewed as an interim solution to turn
around the weak banks.

It has also been suggested in informed quarters that in such banks, there sh ould be a
control on the growth of risk assets. depending on their degree of weakn ess. Such
actions wou ld need 10 be complemented by addressing the underlying causes of
inefficiency in the working.< of these banks, particularly in the areas of autonomy in
bank management, staff resizin g, bran ch rationalisation, and changes in work culture, for
such restructuring to be viable in the long-run .The question of weak banks is sensitive in
character, given the political-economy considerations and stiff opposition from un ionized
leadership tothe closure and downsizing of these institutions.

The Union Budget 2000-01 announced the setting up of a Financial Restru cturing
Authority

{FRA) in a modified form, from the one suggested by the Verma Committee in respect
or any bank considered to be potentially weak. The FRA, comprising experts and
professionals, wou ld be given powers to supersede the Board of Directors on the basis of the
recommendati ons of the Reserve Bank.

6. Non-Performing Assets: Although non -performing assets have been substan tially
reduced since regulation was tightened in 1993, especially in the PSBs, the momentum bas
recently slowed down and the levels of NPAs remain high compared to internati onal
standards. As at end-March 2000, the gross NPAs to total assets of SCBs (excluding RRBs)
st ood at 5.5 per cent; n et of provisions, it was 2.7 per cent. The PSBs gross NPA to asset
ratio was slightly higher at 6.0 per cent and 2.9 per cent , net or provisions,
respectively (Exhibit 2)". The NPA s of US bank.< in 1997 were I .I per cent of loans and
0.66 per cent of as.<ets (Goldstein, 1996). The comparable figu res for other countries
were 1.0 per cent for Korea, 7.6 per cent for Thailand, 5.9 per cent for Brazil and 3.3 per
42
cent for Japan.

Studies on N PA in the Indian oontext suggest that the problems of N PAs have a
sizeable overhang component, arising from infirmities in the existing processes of debt
recovery, inaclequate legal provisions for foreclosure and bankruptcy and difficulties
43
in the execution of cou rt decrees . As a consequence, many i nstitutions have been
adopting ingenious ways of su ppressing the true level of N PAs, thus resorting to 'ever-
green ing'..... The problem is exacerbated by the regu latory provisions for loan

classification ,,,:f-b-v1
:f in1ema1.ional bes:t prnctioes. 011e such case is i11 regarcl to co11sortiu1n
lending. For

ins1ance, a loan account beco1nes non·perforn1i ng if the i111crcst/installlnc111 is not pnid for
two £1unrters. Beside<.. even i n a consortium, each bank hrL< to clfL<Sify the borrowa l
accoun ts according to its own record of recovery . The operatjon of these t wo provis ions
oft en crentes a piquant sit u at ion wherein each member of the consortfom reports an
accoun t a.< a perform ing asset , when. in pract ice, at the aggrega te level. it is a non -
pcrfonning loan!

Operat ionally. it seems impruden t t o t reat all non -pcr fonning loans as a single
·catch-al l' category. Broadly. tl1cy can be categori1.cd into several categories. viz..
loans to agricultura l sector . directed lending.loans to small enterprises and loans to
corporate sect or . Many of the directed loans arc subsistence loans. where default
rates arc high and recovery prospects not bright . As regards loan to agricult ural
borrowers. legal impedi ments often prove to be a challenging proposit ion for banks to
recover their dues.... Loans to small enterprise become difficu lt to recover due to in -
ordinate judicial delays. Even if court decrees can be obt ained towards recovery.
by the time the charge of the assets is taken. its rclllizable value is signilicanLly
diminished becnusc of several reasons includ in g deprecim ion ol' the asset. lack of
borrowers. limited market value of the asset, with the concomi tan t effect that such
decrees arc not executed. As regards corporate loans. sui ts pend ing/referred to
Board for Industrial and Financial Reconstruction leaves little headroom for banks to
effect recovery. TI1e banks also suffer from the dilemma of a working capi tlll lcnder.In
a prot ected/regu lated economy, the propensity of an entrepreneur to continuously
upgrade h is technology/machinery is low, and therefore, tl1e average age of tl1e mach inery
is high.Consequently. the working capital lender fi nds himsel f in a sit ua tion of increasing
commitmen ts m-.i-visrapidly depreciating.outmoded equipment and outdated
technology. Such loans, whic h are large in number in Indian banks , become highly
vulnerable to the market forces when the econ omy is opened up, with the possibility of
slippage of these loans into non -performance. Under such a scenario, there remains
the'exed issue as to who would take the decision towards write-offs. Inadequate
corpora te governance practices coupled with problems of fixation of accountability leaves
littlemaneuverability for banks towards an all-out recovery drive. \V ith the environmental
changes that arc taking place, it seems that the credit portfolio of banks is becoming
vulnerable and the issue of NPAs would need to be tackled bead-on.

It needs to be realised that there are no ·quick-fix' solutions in tackli ng the NPA
problem.

Prospectively, a lasting solution to the viscous problem of NPA.< can be achieved

when financial institutions put in place a sophisticated system of credit assessment and an
integrated risk management mechanism, backed by a prompt and efficien t legal
framework. In a situation of liquidity overh ang, banks, in their attempt to book fresh
business and maximise returns may go in for selection of assets which may later tum
out to be cases of ad,-erse selection, resulting in NPAs. HO\vever, if the banking
system is equipped with balanced prudential norms, these problems can, to a large ext ent,
be minimised, if not avoided. This calls for organisational restructuring, i mprovement in
manageria l efficien cy, skill upgradati on for proper asses.<ment of creditworthiness and an
attitudinal change towards legal action (Jalan, 200 I ).

7.Legal Framework: The is.<u e of NPAs is intimately related t o the quest ion of legal
framework. The legal framework sets standards of behaviour for mark et parti cipants,
details of rights and respon sibi lities of transacting parties.as.<ures that completed
transactions arc legally binding and provides regulators with the teeth to en force standards
and ensure complian ce and adherence to law.The legal framework is a key ingredient for
limiting moral hazard . In developing and transition countries, i ncluding those that fall
under the rubric of emerging mark ets. the.re is often a ba.•ic need for workable laws on
contract. collateral and bankruptcy proceedings .a.• well as a need to implement and
stream li necoun proceduresfor seekin g

effective and rapid remedy under these laws. But the issue extends also to highly
developed legal and judicial systems because the continual stat e of inno,•ation and
evolution of new financial produ ct s can outrun existing legislation and raise fine points of
law.The banki ng syst em requires a legal syst em, which facilitates the enforcement of
financial contracts. The syst em mu st not only be impart ial, but also display sufficient
understanding of financial transactions so that the banki ng syst em can rely on fair and
prompt enforcement of their contractual rights and obl igations In India. prior 10 the
Recovery of Debts Due lo Banks and Financial lnslitu tions Act , 1993, tl1c 1wo modes
available 10 banks to recover their debts or realising tlie securities pledged 10 them had
been 10 tile a suit against a borrower in the Civil Courts and retaining the pledged
goods as collatera l till debts were realise<!. or alternately. selling the goods by giving
prior notice to tl1c borrower w itlioul cou rt intervention. However. since the CourtS were
noodcd with such mauers, settlement of such claims were inevitably long delayed.
which meant a deterioration in the quality and a dellation in the commercial value of
the sccuri1y assets charged by the borrower on the lending institutions, compelling the
former lo write-Off such debts. Further, Section 22 of Sick Industrial Com panies (Special
Provisions) Acl, 1985 provides that once a sick company" stands referred to the Board
for Industrial and Financial Reconstruction (BIFR), no proceedings for (I) winding up
su ch company , (2) for execut ion of the propertiesof such company, or (3) the
appointment of a receiver thereof and (4) no suit filed for recovery of money ,can be
effected, except with the consent of BIFR.This enabled the borrowers to take refuge by
getting their companies referred to B FR, and gaining automatic imm unit y from suits
or actions for

recovery of dues."A significant portion of bank funds has, therefore, been blocked
in u nproductive assets, whose value keeps on deteriorating with the passage of time.""
This has also been one of the m ajor contributory factors behind the high NPA levels in the
Indian bankin gsector.

The Recovery of Debts Due to Banks and Financial Institutions Act, 1993, suggested a six-
month time frame for disposal of every application for debt recovery through the
recently instilu led Debt Recovery Tribunals (DRTs). Such limits often cannot be
respected given !he current operational state of the lribunals, including poor location,
9
lack of appropriate stafting' an d !he virt u al absence of modem office infrastructure ,
including information techn ology support This has undu ly len gthen ed the time lag for
hearings and even further time is expended for issue of recovery certificates. Data
reveals !hat a. a1 end-March 1999, ou1 of !he total number of 21,781 cases involving a
su m of Rs.18 bi llion transferred to/tiled with the DRTs, the number of cases decided
was 3,774 or 17.3 per cent of !he total and they

accounted for 10 per cent of the 101al locked-up amounl in the cases transferred to/ tiled
wilh DRTs. It is imponan1 that the automatic n at ure of !he blanket immun ity
granted by !he present scheme of Sick Industrial Companies (Special Provisions) Acl,
1985 be suitably rectified to remove th e incen tive for

promo1ers 10 ge1 !heir companies declared as sick 10 perpetuate defau lts or nego1ia1e
more favou rable terms. More recen 1 work in this area is renectcd in the Government of
India's cons1i1u 1ion of an Expert Group under the Chairmanship of Shri T.R.Andhyaruj
ina, former Solicitor General of India, 10 suggest appropria1e amendmen1s in 1he legal
framework affec1ing lhe bankin g sector"'.The Commiuee, in i1s Rcporl submiued
recen1ly 10 1he Govemmen l recommended , among 01hcr 1hing, . 1he crea1ion of a new
law gran1ing s1n1u1ory power of possession and sale of securi1y direc1ly 10 bank s and
financial i ns1i1u1ions and creation of n new Securi1isn1i on Ac1. which wou ld be an
u mbrella ac1 conferrin g legal sancti1y 10 transfer of fu1ure receivab les. II has also
su gges1ed the provision of addi1ional avenues of recovery of dues 10 banks and
financi al ins1i1u1ions by empowering 1hcm 10 rnkc possession of sccuri1ics and sell 1hcm for
recovery of loa11s \Yitl1out 1l1c COUl'l's i11tc1·vc11tion. 11 is in1portant to note in tl•is context thnt the
CO · opcrmive sec1or has su ch a sys1cm of uiking possession of secu r i1ies i n case of
default: su ch a sys1cm has

however, proved lo be incffcc1ivc.The Advisory Commiu ee on Bankrup1cy Laws has also

made several in1cri m rcoommc ndations, incl uding a scparm e comprehensi ve Bankrupt cy
Code to deal with corporate bankrup1cy and ins1i1u1ion of a S1>ccial Bankrnptcy Bench
in each High Cour1, 10 tackle the problem. II needs 10 be rei1cra1cd Lha1 1hc legal syst em
be made su fficient ly prompt , responsive and efficient to take care of Lhe problems facing
1hc banking scc1or.

8. Trnnsparc11ey and Disclosu re: In the Indian conLext , the Lrnnsparcn cy and disclosure
standards have been enhanced 10 mec1 i nLernaLional siandards. 111c range and exLeni of
disclosures has been gradu ally increasi ng over the last couple of years in order 10
provide a clearer picLure of balance sheets to the fi nancial community. Since March 31,
2000, banks opcrnting in India have been disclosing in their published accounts
information relating Lo 1naLurily paucrn of loans and advances, invesln!Cnt securities.
deposi ts and borrowings.foreign currency asseLs and liabilities, movements in NPAs and
provisions and lending 10 sensitive sectors (capital markel scc1or, l'Ca l estate secLor and
commodities seclor). The Memorandum of Undersiandin g (MOU) signed with Lhe Reserve
Bank each year has compelled bank managemen1 10 adhere 10 certain minimum
performance standards. More so, when banks are raising capital from the market, they
arc accountable 10 the public/shareholders. Such Lransparency of operations is essential to
minimize informational asymmeLry between the regu lator and regulated and facilitate
effective moni1oring of banks.

Two issues arise in this context. The first relates to the availability of raw source data.
Presently, the maj ori1y of the banking data is housed with the RSI and only those data
which arc released by the RSI is available to the financial communi1y; all other data arc
secondary . ll needs to be appreciated that this poses a serious handicap in
understanding and analyzing the devclopmcn1s in the banking sector. is poses a
serious handicap in understanding and analyzing the developments in lhe banking
sector.

Therefore, in order to impart greater transparency, while lhe regulatory data,

which is confidential in natutt, would need to be kept in abeyance from publi c
domain, all olher data could be warehoused outside, where it would be freely
accessible t o the public at large. Secondly, while lhe disclosures standards have
been enhanced. several areas of lacunae still remain, viz., complete breakup of
income, discontinuance of lines of business, eniry into newer lines of business,
information detailing maturit y and repricing of all assets and liabilities. cumulati'-e
pro,tisions as against loan losses with the movement in provisions ace.aunt, details of
contingent liabilities. details of risk "'ejghted assets, leverage ratio, details of legal risk, are
still not being disclosed. If recent experience is to be believed. lhe compliance of
norms for transparency often turns out to be 'technical compliance', whereas !here
is little headway as regards

actual compliance wilh norms. The recommendations of lhe Advisory Group on

Banking Supervision (Chairman:Shri M.S.Verma) are pertinent in Ibis regard.

9.Potential Conflkl as Owner/Supen'i or:A large part of

banking operations in India isaccounted for by PSBs
The competitive impulses engineered by the RBI in the cause of enhan cing
efficiency have to

take into accou nt the extent of response of PSBs and lhe Government as
!heir principal to competiti ve pressures.Similarly, the regulatory and prudential
considerations advanced by the RBI have to reckon wilh the impact on and
response of the PSBs and Government as their principal. It is n ot pos.•ible to
ignore the systemic implication< . of the large sub-system of PSBl'.The RBI is both the
owner as well as lhe regulator of the State Bank of India (SBI). A tran.•fer of the
ownership of SBI to the Government. more soat a time when there is a general
move t owards reducing Government presence in the banking sector might be a
retrograde step. since the autonomy which SBI had with its ownership being with
the RBI might get compromised when the same istransferredto the Government. A
morepractical approach might be to go for a two-stage solution. In stage I. a truly
independent Board of Directors needs to be nominated by the RBI. In stage 2. lhe
nominees of RBI needs to be form Trust. where lhe shares of SBI can be deposit ed.
Such a move.while allowing greater operational autonomy toSBI will also en able it t o
enhance corporate governance.

10. IMPLEMENTATION OF BASEL II

Basel I I implementation is widely acknowledged as a signi ficant challenge faced by

both banks and the regulators internationally. It is true that Basel II
implementation may be seen as a compI iance challenge. While it may be so for
some banks, I would venture to mention that Basel II implementation has another
d imension \Which offers considerable opportunities to banks. I would like to
highl ight two opportunities that are offered to banks, viz., refinement of risk
management systems; and improvement in capital efficiency. Basel 2 requires
more capital for public sector banks in India due to the fact that operational risk is
not captured under Basel I.

Basel II is the revised capital accord of Basel I. Basel II accord defines the
minimum regulatory capital wh ich is to be allocated by each bank based on its risk

profile of assets. Banks have to maintain the capital adequacy ratio (CAR) of m
inimum

9 %. As per RBI,banks which are getting more than 20% of their businesses from
abroad have to I mplement Basel ll. But most of the banks are now interested to
implement Basel II.
Implementation of Basel ll is seen as one of the significant challenges for Public
Sector Banks. Implementation of Basel U will require more capital for Publ ic Sector
Banks in India due to the fact that operational risk is not captured under Basel I

Jn ICRA's estimates, Publ ic Sector Banks would need add itional capital to the extent
of Rs.90 bill ion to meet the capital charge requirement for operational risk under
Basel ll.

The challenge for the banks \Vould be to quantify risks(credit concentration risk,
interest rate risk in the banking book,business and strategic risk, l iquidity risk,
and other residual risks such as reputation risk and businesscycle risk) and then,
to translate those consistently into an appropriate amount of capital needed,
commensurate with the bank 's risk profile and control environment.

N eedless to say, this would cal l for instituting soph isticated risk management
systems,including a robust stress-testing and econom ic capital al Pub l ic Sector
Banks wou ld be required to use fully scalable state of the art technology, ensure
enhanced i nformation system security and develop capabi l ity to use the central
database to generate any data required for risk management as well as
reporting.location framework.

The most important Pi llar 2 challenge relates to acquiring and upgrading the
human and technical resources necessary for the review of banks responsibilities
under Pillar I.

Public Sector Banks woul d be required to use fully scalable state of the art
technology, ensure enhanced infommtion system security and develop capabil ity
to use the central database to generate any data required for risk management
as well as reporti ng.

The costs associated with Basel II implementation ,particularly costs related to

infonnation technology and human resources, are expected to be qu ite
significant for Publ ic Sector Banks.

Minimum Capital Allocation for credit risk

To allocate the capital for any of the above risk, it should be

quantitatively measured.
Chapter 4-

Monetary policy
Monetary policy is a policy f or mulated by the central bank ,i.e., RBI (Reserve
Bank of India) and relates to the monetary matter s of the country.

The policy involves measures taken f or regulating the money supply, avai la bility
and costofcreditintheeconomy.

The policy also oversees distribution of c redit among users as well a s borr owing and
lending rates of interest. In a developi ng country like India, it is significant in the
promotion of economic growth.

The various instruments of monetary policy include varia tions in bank rates, other
interest rates, selective credit controls , supply of currency , variations in
reserve requirements and open market opera tions.

Objectives of Monetay Policy

Whi lethe mainobjec tive of monetary policy is economi cgrowthaswellaspr iceand
exchange rate stability,there are other aspects that itcan helpwith aswell.

 Promotion of savi ng and investment: Since the monetary policy contr ols the
rate of interest and inflation within the country , it can impact the savings
and investment of the people. A higher rate of interest Translates to a
greater chance of investment and savi ngs, thereby, Maintaining a
healthy cash flow withinthe economy.
 Contr olling the imports and exports: By helping industr ies secure a loan at a
reduced rate of interest, monetary policy helps export-or iented units to
substitute imports and increase exports.This, in turn, helps improve the
conditionofthebalance of payments .
 Managing business cycles: The two main stages of a business cycle are boom
and depres sion.Monetary policy is the greatest tool usingwhi ch boomand
depress ion of business cyc les can be controlled by managing the credit to
contr ol the supply of money. The inflation inthe market can be contr olled
by reducing the supply of money. On the other hand, when the money
supply increases, the demand inthe econo mywi ll alsowitness a rise.

 Regulation of aggregate demand : Since monetary policy can contr ol the

demandin aneconomy,itcanbeusedbymonetary bymonetary authoritiesto
maintain a ba lance between demand and supply of goods and services.
When credit is expanded and the rate of interest is reduced,it allows more
 people to secure loans f or the purchase of goods and services. This leads to
the r ise in demand. On the other hand, when the author ities wish to reduce
demand,theycanreduce creditand raisetheinterest rates.

 Generati on of employment: As monetary policy can reduce the interest

rate, secure a
securealoanf orbus inessexpansion.This can leadto greater employment
