The Indian Banking Sector

Post-1991 Banking Sector Reforms

1. Reduction in CRR and SLR release more funds with the banks for commercial lending

2. Interest Rate Liberalization: System of Market-determined Interest Rates. Started with Loan
interest rates & followed by those on deposits.

3. Private Sector Banks allowed to operate along with Public Sector Banks.

4. Foreign Banks also allowed (FDI in Banking)

5. Capital Adequacy Reforms

6. Reforms related to resolution of Non-Performing Assets (NPAs).

(Read Page no. 43-45; Yellow Book under Narasimhan Committee Recommendations)

Balance Sheet (BS) of a Commercial Bank

Capital Adequacy: Meaning, Rationale, & Types

• Assets of a bank can be risky or there is a possibility of loss with these, in particular the risk of
credit default or non-performing assets.

• To handle these risks, banks should have adequate or minimum capital & reserves (C&R)so that
these losses can be balanced through extra liabilities.

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• If such C&R are easily available (or highly liquid) to banks, these are called Tier I Capital. If
these are available, but not as easily as Tier I, then it is called Tier II Capital. Both are good
quality capital but Tier I is of better quality than Tier II.

Common Equity Tier (CET) I Capital

• What makes CET I or Share Capital unique is that it is considered as best quality capital (an
example of Tier I Capital). It is raised when a bank sells its common shares to public which gives
highly liquid capital.

• Disclosed Reserves are also highly liquid & hence Tier I Capital.

• Revaluation Reserves can be raised by a bank if its assets are revalued at current market prices.
But since raising such capital can be time-taking & not predictable, these are not highly liquid,
hence a part of Tier II Capital.

BASEL Norms on Capital Adequacy

• These norms are the global norms on capital adequacy decided by the central bankers’ meetings at
Basel (a city located in Switzerland), the HQs of the Bank for International Settlement (BIS).

• BASEL I Norms were introduced in 1988 and required the banks to have at least 8% CAR in order
to cover credit risk (possibility of loss to the banks due to credit defaults).

• In India, BASEL I norms were introduced by RBI in 1992 (with minimum CAR of 9%) on the
recommendations of Narasimhan Committee. By 1997, most Indian banks were compliant to the
norms but full compliance came only by 2005-06.

BASEL II Norms, 2004

• Three Pillars:

1. Minimum Capital Requirements

2. Supervisory Requirements: The commercial banks are expected to have separate department for
“risk-management” under supervision of the central bank.

3. Market Discipline: Refers to transparency requirements under which the balance sheet of the banks
should be made public.

Minimum Capital Requirements in BASEL II

• Refers to minimum CAR requirements and it was maintained at same level of 8%.

• However, for RWAs calculation three types of risks were identified:

1. Credit Risk (already discussed)

2. Market Risk: Possibility of loss to the banks due to change in market price of assets & liabilities.
e.g. change in market interest rate, bond prices etc.

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3. Operational Risk: If loss to banks happens due to failure of systems, processes, and human
resources. e.g. fraudulent banking transactions due to insecure net banking system.

Background to BASEL III Norms, 2010

• Despite BASEL II Norms, the US banking sector went through the Sub-Prime Mortgage Crisis in
2008.

• The root cause of the crisis was significant amount of housing loans given by the US banks to the
sub-prime (less credit-worthy) borrowers as a part of expansionary monetary policy in US since
2000.

• Large-scale defaults on these loans and falling housing prices created a vicious cycle & US banks
faced heavy losses leading to crisis.

• Big US banks like Lehman Brothers filed for bankruptcy in the hope that government would bail
them out.

BASEL III Features

• Same three pillars as BASEL II but more stringent requirements.

• Although minimum CAR is kept unchanged, the banks are required to keep more capital in Tier I
& within that in CET I.

• Apart from CAR, banks need to create a Capital Consumption Buffer (CCB) from their own
resources like by cutting down on dividend and bonus payments. Minimum CCB is 2.5% of
RWAs.

• Thus, effectively a bank needs to keep 10.5% of RWAs (CAR of 8%+ CCB of 2.5%) in C&R
restricting their ability to provide credit.

BASEL III Features (contd.)

• Banks also need to keep at least 3% of their total assets (not RWAs) in Tier I capital, a concept
called Leverage Ratio (LR).

• BASEL III, identifies Liquidity Risk apart from three types of risks discussed earlier. It refers to a
situation when a bank fails to fulfill liquidity demand of their depositors or borrowers.

• To handle it, banks need to maintain 100% Liquidity Coverage Ratio (LCR). It means whatever
cash outflows a bank expects during the next 30 days, it needs to keep the same amount presently
in certain high quality liquid assets (HQLAs) like cash, short-term government securities or a part
of SLR.

Impacts of NPAs on Banks

• NPAs imply that the loans given by the banks are no longer acting like an asset as the interest
earnings have reduced & in worse cases, even principal amount can be partially impacted, thereby
lowering bank’s profits.

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• Although generally these loans are given on the basis of some collateral in the form of movable or
immovable assets of the borrowers. But getting control over these collaterals can be time-taking &
costly process. Also, sometimes collateral value may not recover the entire amount due to the
banks.

Provisioning: Meaning, Rationale & Impacts

• Provisioning for NPAs means that the bank should take-out a proportion of their NPAs from their
earnings and keep it on the capital side.

• Its rationale is to prepare the banks to handle losses from credit defaults. Thus, provisioning
requirements increase as asset quality degrades. If this is not done, banks can face a sudden loss at
the time of default thereby taking it into a crisis.

• However, provisioning restricts future ability of banks to give loans leading to lower profits in
future.

• NPAs, therefore, restricts both present & profit flows for the banks.

Reasons behind NPAs

• Theoretically, NPAs can arise due to two factors.

• First, lack of ability to repay loans by the borrowers. It means the purpose of taking loan did not
succeed often due to factors beyond borrowers’ control. e.g. loans defaulted by farmers due to
monsoon failure or loans defaulted by companies due to slowdown.

• Second, lack of willingness to repay loans . It means that despite ability the borrowers are not
willing to repay loans often due to legal loopholes in loan recovery process.

• Although both factors may simultaneously operate, it is crucial to find the more crucial factor at a
point to have workable solutions to the NPA problem.

Indian NPA problem (Yellow Book: page 47-48)

• Narasimhan Committee defined & identified NPA problem in 1991 & recommended legal reforms.

• Recent NPA problem can be traced back to 2008. During 2003-08, Indian Economy was in high
GDP growth phase leading to more demand for loans, particularly by sectors like steel and
infrastructure.

• Due to Global Financial Crisis of 2008, India also went through a slowdown reducing ability of
these sectors to repay the loans leading to higher NPAs.

• Willing defaulters have also contributed to higher NPAs, but it is mainly lack of ability problem.

Twin Balance Sheet (TBS) Problem

• It means that when the borrowing firms face losses due to slowdown, it worsens their balance
sheet. It also results in higher loan defaults leading to NPAs or losses to banks worsening the
bank’s balance sheet.

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 • Indian NPAs are identified as TBS problem which is an example of lack of ability problem.

• It also indicates that majority of NPA solutions should try to improve balance sheet of the
defaulting firms so that they can repay the loans thereby improving bank’s balance sheet.

Solutions to NPAs

1. Legal Reforms after 1991through N. Committee:

• Setting up Debt Recovery Tribunals (DBTs) to speed up the resolution of NPA cases. These
cases refer to the legal conflict between the bank & defaulting borrowers. Quick resolution
discouraged borrowers to willingly default.

• Securitization & Reconstruction of Financial Assets & Enforcement of Security Interest

(SARFAESI) Act, 2002: Under this banks were allowed to take control over the securities
(collaterals) of defaulting borrowers without intervention of the courts (after 6 months notice). It
proposed to save time & cost to banks in acquiring securities.

Asset Reconstruction Companies (ARCs)

• ARCs were set up under SARFAESI Act. These are a type of NBFCs which can buy NPAs from
the banks at a discount & try to recover it. Banks get rid of NPAs from their balance sheet &
require no provisioning.

• ARCs can control securities without courts’ intervention.

• ARCs also get some role in the management of the defaulting company with the expectation that
improved performance can help recover NPAs.

• Despite some initial success, ARCs have not helped in recovering large amount of recent NPAs.
There is often a conflict between the banks & ARCs on the discount at which NPAs are traded.
Also, being an NBFC, an ARC may not be able to manage companies of different sectors.

Restructuring of NPAs

• Under standard restructuring called Corporate Debt Restructuring (CDR), defaulting corporate
borrowers are provided with some concessions in repaying loans like lower interest rates & longer
repayment period.

• Two more types of restructuring in India are Strategic Debt Restructuring (SDR) and Scheme for
Sustainable Structuring of Stressed Assets (S4A). In both types NPAs are divided into two parts
viz. debt & equity. Debt part is restructured in a similar way as CDR.

• Under equity, a part of NPAs is converted into equity or shares of the defaulting firm which are
held by banks. With shareholding, banks get some role in management of the firm helping in NPA
recovery.

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 Restructuring of NPAs (contd.)

• Despite similarities between SDR & S4A, there is a crucial difference. Under SDR, there was no
upper limit on shareholding of the banks and they could have held even 51% or more shares of
defaulting company. In that case these banks would have become owner of the company.

• This limitation was removed under S4A under which the banks were allowed to hold below 51%
shares.

• But in both SDR & S4A defaulting firms’ management, irrespective of the sector it belongs to,
goes in the hands of the banks restricting its success.

Other Limitations of Restructuring

• Banks’ incentive to restructure NPAs, is that for sometime (generally a year) these NPAs are not
reflected in the banks’ balance sheet. It gives more ability to banks to provide loans for this time.
But due to this banks can go for excessive restructuring where it is not a suitable solution.

• Willing defaulters can also pressurize banks for restructuring loans & banks can be in nexus with
them

• On paper, this reduces NPAs, but only temporarily & in future can make NPA problem even worse.

• Thus, experts look at banks’ Stressed Assets as the real indicator of problem which is sum of
NPAs, restructured NPAs and write-offs.

Insolvency & Bankruptcy Code (IBC)

• IBC legislation in 2016 has been proposed as the best solution to the NPA problem so far. Overall,
this legislation aims to ensure smoother exit of the inefficient forms from the economy so that
liberal entry of efficient firms can happen.

• Under IBC, the firms with higher NPAs are referred to NCLT which has two options. Ideally it
should bring a Resolution Plan (RP) for the firm. Under this, the insolvency professionals hired by
NCLT restore the declining value of assets of the firm & sell it to another firm in the same or
similar sector so that its management is under capable hands (improvement over ARC &
Restructuring).

IBC (contd.)

• In case RP is not successful in a time-limit (330 days at present which was 180 days to begin with)
then NCLT proceeds towards Liquidation of the defaulting firm. Under this, the assets of the forms
are sold at whatever price it fetches.

• Liquidation should be minimal as it hurts economy through lower growth & loan recovery as well
as higher unemployment.

• In 2017, RBI had identified 12 largest defaulters for RP within 180 days. One successful RP
during this time was that of Bhushan Steel which was bought by TATA Steel along with 63% of
loans being repaid to banks (37% haircut).

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 Project Sashakt

• IBC could not bring as many RPs as proposed by RBI. In 2018, Project Sashakt was brought by
government under which NPAs greater than Rs. 500 Crores to be resolved by an AMC before
NCLT. It has diluted IBC role in resolving NPA problem.

• For NPAs between Rs. 50-500 crores, Lead bank chosen by Inter-Creditors Agreement will bring
RP within 6 months. Also called Bank-led Resolution.

• For NPAs below Rs. 50 crores, individual bank to bring RP within 3 months.

Limitations of IBC

• After Project Shashakt, very high-value NPAs are not being resolved.

• Delays in bringing RPs

• Number of Liquidations have increased.

• RPs have often involved higher haircuts (less loan recovered)

• Successful RPs have come from selected sectors like Steel.

(Read page no. 52-55 from Yellow Book)

Public Sector Banks (PSBs) Reforms

• Indradhanush is a set of such reforms, motivated by the recommendations of Nayak Committee.

• Seven part of Indradhanush reforms

1. Appointments: Separation of top positions like Chairman & MD of a PSB.

2.Bank Board Bureau (BBB) for making appointments.

3. Capitalization of PSBs: Refers to Government providing capital to PSBs to increase their CAR.
Two common mechanisms for this are through Budgetary Resources & Recapitalization Bonds. These
bonds are issued by government & bought by PSBs. The government uses this long-term borrowing to
infuse capital. It has less impact on Fiscal Deficit as only interest payments increase it.

Indradhanush (contd.)

4. Destressing: Reducing NPAs by Restructuring NPAs of PSBs & restarting stalled projects of
defaulters

5. Empowerment: Less government intervention in PSB functioning

6. Accountability: Ranking PSBs on Key Performance Indicators and rewarding the better performers

7. Governance Reforms: Improving systems, processes, skills etc. in PSBs. e.g. CORE banking
Solutions.

Except capitalization, Nayak Committee had proposed all reforms.

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 Mergers & Acquisitions (M&As) of PSBs

• M&As or amalgamation of banks refer to bringing two or more than two banks together to have a
bigger bank. Mergers are between similar sized banks, else these are acquisitions .

• Expected benefits of M&As:

1. Economies of Scale operates if banks getting merged had some similar attributes like balance sheet,
management, CORE banking solution etc.

2. Lesser Number of branches reduces cost of operation increasing profits.

3. In acquisitions, a stronger bank expected to improve performance of a weaker bank.

Issues around M&As of PSBs in India

• India began with such policy in 1995 when PNB acquired New Bank of India (NBI) with the
expectation that NBI’s performance will improve. However, that could not happen.

• Since 2007-08, the merger of SBI with its 7 Associate Banks started. Initially, 2 of these banks
were merged with remaining 5 getting merged only in 2017. The merger has been successful so far
but these banks were similar in certain parameters like management & CORE banking solution &
economies of scale worked.

• In 2019, Bank of Baroda, Dena Bank & Vijaya Bank got merged. Its too early to comment on its
success or failure but these are having many dissimilar features.

Recent Megamerger Plan of PSBs

• From April 1, 2020 government has announced merger of 10 PSBs into 4 PSBs.

• OBC & United Bank of India have been merged into PNB to become 2nd largest PSB after SBI.

• Syndicate Bank & Canara Bank merged.

• Indian Bank merged with Allahabad Bank.

• Union Bank of India merged with Andhra bank & Corporation Bank

• This M&A expected to lead to benefits as discussed and also create bigger sized banks. But these
are dissimilar on many counts. Also, it can lead to “Too Big to Fail Banks” which means banks
can take more risks if bigger in size as government implicitly guarantees help during crisis.

Financial Inclusion (FI)

• Refers to the provision of basic banking & other financial services to the low-income population,
particularly in remote areas.

• PSBs have played crucial role in achieving this goal since nationalization of Banks in 1969. One
of the issues around M&As of PSBs is that it can negatively impact FI due to lesser number of
branches.

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• Apart from standard banking operations, some specific schemes have been launched to achieve FI
in the last decade. Two ideal pillars that any such scheme should achieve are Cost-effectiveness &
Easier KYC Norms.

Business Correspondent Scheme, 2005

• Under this an individual acting as business correspondent (BC) or Bank Mitra is appointed by a
bank & provide basic banking services by visiting remote areas. It largely satisfies both the pillars
of FI.

• But some limitations seen in the scheme are

1. BCs lacking professionalism

2. BCs complain of lower remuneration

• Ideally the scheme should be continued by simultaneously by training & providing better
remuneration to BCs. Its still among most cost-effective scheme.

PM Jan Dhan Yojana (PMJDY), 2014

• Most popular FI scheme under which government has given many incentives to open more bank
accounts for FI which are

1. Zero balance accounts

2. Easier KYC Norms

3. Free debit card & mobile banking facilities

4. Life Cover (Rs. 30,000) & Accident Cover (up to Rs. 2 Lakh) without premium required.

5. Overdraft Facility of up to Rs. 10,000

• Due to these factors, FI has improved. More than 85% of adult population has bank accounts as
compared to 55% before this scheme.

Limitations of PMJDY

• Not cost-effective for banks as revenue is lower & expenditure is higher

• Many accounts are Duplicate i.e. opened by persons already having an account earlier & not FI

• Many accounts are Dormant or inactive due to lack of transactions in them

• Despite its success, the scheme should remove these limitations. FI should also look into demand
side of financial services.

Payment Banks (PBs)

• On the recommendations of Nachiket Mor Committee under RBI, PBs were set up in 2015.

• PBs can accept deposits up to Rs. 1 lakh

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• PBs cannot give loans or issue credit cards

• PBs must invest at least 75% of NDTL in Government Securities (gives them revenue in absence
of loans)

• PBs operate with lesser number of branches & ATMs. Focus is on IT-based banking (cost-
effective)

• PBs allow for easier KYC (like e-KYC)

• PBs were allowed to be opened by RBI by those entities already having some business in remote
areas. e.g. Airtel PB, Paytm PB, Indian Post PB etc. (saves cost & time of FI)

Limitations of PBs

• Despite ideal feature PBs faced some limitations:

1. Easier KYC needs verification from third party (after Airtel PB had opened accounts without
approval) making it difficult for new customers.

2. PBs claim to benefit Migrant workers by allowing them to remit money through shops or POs
linked to PBs. But, complaints of higher commissions charged have come.

3. IT-based banking needs basic infrastructure like electricity & internet not available in many remote
areas

Challenges before FI in India

• Lack of Infrastructure (already discussed)

• Lack of Credit Provision: Although there are schemes like PSL in banks & also Small Finance
Banks (yellow book), credit provision is much lower than demand.

• Lack of Financial Literacy

1. Lack of Awareness about financial services

2. Lack of Capabilities to use these services

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