Commercial Banking System & Role of RBI

December 2023 Examination

1) Independence of Central Bank is very crucial for impartial functioning and fair play in the
economy. Any closeness of Central Bank to Ministry of Finance will not be fair and it will be
viewed as baby of the government and will be looked with suspicion. Do you agree or
disagree with the above statement and what is your stand?

Ans:

Introduction

A central bank’s Independence broadly appeared as a fundamental element for ensuring

impartial economic functioning and truthful play inside an economic system. Crucial financial
institution independence refers to the diploma of autonomy a principal bank possesses in its
choice-making and operational sports, unfastened from undue influence from the authorities
or different external entities. This autonomy is crucial in maintaining economic stability,
controlling inflation, managing monetary policy, and selling long-term sustainable growth.

Concept & Application

Independence of Central Bank: A Necessity for Economic Impartiality:

The independence of a country's central bank from the government's influence has long been a topic of
debate. Some argue that this independence is crucial for maintaining economic impartiality and
ensuring fair play in the economy. In this essay, we will explore the reasons behind the importance of
central bank independence and discuss the implications of its closeness to the Ministry of Finance.
Here are some key reasons why central bank independence is considered important:
1. Monetary Policy Effectiveness: When a central bank is free from political influence, it can focus
on achieving its primary objective, which is typically price stability or controlling inflation. Political
interference can lead to short-term policy decisions that may not be in the long-term interest of the
economy. An independent central bank can make tough decisions, such as raising interest rates to
combat inflation, without the fear of political backlash.
2. Credibility: An independent central bank is more likely to earn and maintain the credibility
necessary to influence economic behavior effectively. If the public and financial markets perceive that
the central bank is subject to political pressure, they may doubt the central bank's commitment to its
goals and the efficacy of its policies.
3. Long-term Planning: Central banks are responsible for implementing monetary policies that have
a long-term impact on the economy. Political cycles are usually shorter than the economic cycles
central banks need to address. Independence allows central banks to take a longer-term perspective in
their policy decisions, reducing the temptation to adopt short-term measures for political gain.
4. Economic Stability: Central bank independence can help maintain economic stability by insulating
monetary policy from political pressures and considerations. This stability can lead to more predictable
economic conditions, which benefit businesses, investors, and the general public.
5. Reduced Inflationary Pressures: Independent central banks are more likely to prioritize low and
stable inflation over political considerations, leading to policies that reduce inflationary pressures and
promote price stability. Low and stable inflation can provide a foundation for sustainable economic
growth.
6. Financial Market Confidence: An independent central bank can instill confidence in financial
markets. Investors and creditors may be more willing to lend or invest if they trust that the central
bank will maintain a stable economic environment.
7. Preventing Fiscal Dominance: Central bank independence can help prevent fiscal dominance,
where the government influences the central bank to finance budget deficits through money creation.
This practice can lead to hyperinflation and undermine economic stability.
8. Objective Decision-Making: Independence allows central banks to make decisions based on data,
economic indicators, and expert analysis rather than succumbing to political pressures, electoral cycles,
or special interests.

FUNCTIONS OF CENTRAL BANK:

 A central bank is a financial institution that is responsible for overseeing the monetary system and
policy of a nation or group of nations, regulating its money supply, and setting interest rates.
 Central banks enact monetary policy, by easing or tightening the money supply and availability of
credit, central banks seek to keep a nation's economy on an even keel.

 A central bank sets requirements for the banking industry, such as the amount of cash reserves banks
must maintain vis-à-vis their deposits.

 A central bank can be a lender of last resort to troubled financial institutions and even governments

Having an apolitical central bank obviously has many advantages.

 Political Cycle vs. Business Cycle: Politicians all over the world are only concerned with staying in
power. They will do whatever it takes as long as they can stay in control. Hence, it can be said that the
actions of the politicians are controlled by political cycles. They become extremely generous and
accommodating during the pre-election years. The business, on the other hand, operates based on
business cycles. It is not necessary that periods of boom and bust will coincide with the political cycles.
Also, if they do, politicians may have a conflict of interest. For instance, if there is too much inflation
during an election year, politicians might simply skip the necessary but unpopular decision of
implementing rate hikes. Hence, it is likely that the politicians will end up jeopardizing the entire
economy for selfish gains. This is the reason why central banks need to be independent. They can take
tough decisions regardless of the election cycle. The economy and elections are not naturally
correlated. Hence, it is imperative that the decisions regarding the economy be taken independently.

DISADVANTAGES: Separating the central bank from the state has many advantages that have been
listed above. However, there are some disadvantages as well.

 Secretive: The biggest criticism against the central bank is that their operations are very secretive.
Many times their actions are completely unexpected. Many financial crises in the past have only taken
place because the central bank took unexpected action. To prevent this from happening again, central
banks need to ensure smooth transitions. Their policies should not be secretive and should not shock
the economy.

Conclusion:

The independence of the central bank is essential for economic impartiality and fair play. It allows for
the formulation and execution of policies aimed at long-term economic stability rather than short-term
political gains. It's worth noting that while central bank independence is generally considered beneficial,
it's not an absolute principle. Some argue that central banks should be accountable to the public, and
there should be mechanisms to ensure transparency and oversight. Striking the right balance between
independence and accountability is a challenge, but it is essential for a central bank to fulfill its mandate
effectively while remaining responsive to the broader needs of society.

2) RBI has different parameters for evaluating the performance of bank. These criteria
emanates from different roles played by commercial banks. Explain the different
parameters on which banks are rated on scale of 1 to 5. Here 5 is rated as
unsatisfactory/poorly performing bank, while 1 rating is deemed as a well-run bank.

Ans :

Introduction

Banks are assessed based on these parameters, and the RBI assigns a rating on a scale from
1 (well-run) to 5 (unsatisfactory/poorly performing) for each parameter. The overall rating of
a bank is determined by considering its performance across all these parameters. This rating
helps the RBI and the public gauge the overall health and stability of the bank. Banks with
consistently lower ratings may face regulatory action or intervention to address their
shortcomings and ensure the safety and soundness of the banking system.

Concept & Application

Reserve Bank of India (RBI) on a scale from 1 to 5, with 5 indicating an unsatisfactory or poorly
performing bank and 1 representing a well-run bank.

Here's an overview of the key parameters considered in these evaluations:

Capital Adequacy (CA):

Capital adequacy is a measure of a bank's ability to absorb losses and protect depositors. It's
determined by the capital adequacy ratio (CAR).
A bank rated 1 has a strong CAR, indicating a substantial capital buffer.
A bank rated 5 may have inadequate capital, suggesting a higher risk of insolvency.

Asset Quality (AQ):

Asset quality assesses the health of a bank's loan portfolio. It focuses on the level of non-performing
assets (NPAs).
A bank rated 1 has a low level of NPAs and a healthy loan portfolio.
A bank rated 5 indicates a high level of NPAs, suggesting significant credit risk.

Management Quality (MQ):

Management quality evaluates the effectiveness of a bank's leadership, governance, and decision-
making.
A bank rated 1 demonstrates strong corporate governance, transparency, and prudent management
practices.
A bank rated 5 may exhibit poor governance and decision-making, which could lead to operational
issues.

Earnings and Profitability (EP):

This parameter assesses a bank's ability to generate consistent profits and sustain profitability.
A bank rated 1 consistently generates profits, has a strong net interest margin, and controls costs
effectively.
A bank rated 5 may struggle to make profits, which could undermine its sustainability.

Liquidity (LQ):

Liquidity measures a bank's ability to meet short-term financial obligations, including customer
withdrawals.
A bank rated 1 maintains robust liquidity, ensuring it can meet obligations without issues.
A bank rated 5 may face liquidity challenges, leading to potential solvency risks.
Capital Adequacy (CA): Evaluates a bank's ability to absorb losses, with a rating of 1 for strong capital
and 5 for inadequate capital.

Operating Efficiency (OE):

Operating efficiency measures a bank's cost structure and its ability to control expenses.
A bank rated 1 operates efficiently, minimizing operational costs and maximizing profitability.
A bank rated 5 may exhibit excessive operating costs, which can hinder profitability.

Compliance (CO):

Regulatory compliance assesses whether a bank adheres to relevant laws, regulations, and RBI
guidelines.
A bank rated 1 consistently complies with all regulations and maintains a strong compliance culture.
A bank rated 5 may have a history of regulatory violations or non-compliance.

Innovative Banking Practices (IBP):

Innovative banking practices consider a bank's adoption of modern technology and practices to
improve services and efficiency.
A bank rated 1 actively embraces innovation, fostering digital transformation and enhancing customer
experience.
A bank rated 5 may be slow to adopt modern practices and technology, potentially falling behind in
the market.

Customer Service and Satisfaction (CSS):

Customer service and satisfaction gauge a bank's ability to meet customer needs and maintain high
service quality.
A bank rated 1 excels in customer service, ensuring high customer satisfaction and loyalty.
A bank rated 5 may face complaints or dissatisfaction, indicating a poor customer service culture.

Sensitivity to Market Risk (MR): Assesses a bank's management of market risks, with 1 for effective
risk management and 5 for inadequate risk control.

The trend of a bank’s performance may be measured in terms of its year-to-year growth majorly in
respect of its revenue, profit volume and business level (which is defined by aggregate of its deposits
& advances). Although these parameters are interlinked, they have also standalone bearing on bank’s
performance. Nowadays, the investment/treasury activities also play a dominant role, besides the
traditional lending function, and hence, they impact the overall asset level and the revenue of a bank.
Therefore, there is a need to assess the growth pattern of treasury income and total assets.

Conclusion
The rating process ultimately determines the likelihood of the rated debt obligation being serviced in
full and on time. The assessment of management quality, the bank's operating environment and its
role in the nation's financial system are used to interpret current data and to forecast how well the
 bank is likely to be positioned in the future. While several parameters are used to assess the risk
profile of a Bank, the relative importance of each of these qualitative and quantitative parameters can
vary across banks, depending on its potential to change the overall risk profile of the bank concerned.
The final rating decision is made by the Rating Committee after a thorough analysis of the bank's
position over the term of the instrument with regard to business fundamentals.

3) Today most of the banks are focusing on recovery of Non-Performing Assets (NPAs). A
large chunk of bank’s money is locked in these assets. Major defaulters are intentional who
plan to defraud the bank and run away. The other types of defaulters are those, who
because of circumstances or due to some inabilities are unable to repay the bank loans.
Banks have to make huge provisions for NPAs, which reduce the profitability of the banks.
However, new legislations have been passed expediting recovery process but more needs to
be done. In light of above statements:

a) Write the major steps taken for recovery since last 10 years

Ans:

Introduction:

Non-Performing Assets (NPAs) are a significant concern in commercial banking. They represent loans
or advances for which the principal or interest payment has remained overdue for a specified period,
causing a drain on the bank's profitability and financial health.

The borrowers who default on their loan repayments can broadly be classified into two categories:
intentional defaulters and ability defaulters. Intentional defaulters are those who plan to defraud the
bank and evade repayment, while ability defaulters are those who are unable to meet their debt
obligations due to financial difficulties or changing circumstances.

Concept & Application

Non-Performing Assets (NPAs) are loans or advances that have stopped generating income for a
lender, typically due to non-payment by the borrower. Over the past decade, many steps have been
taken by governments, regulatory authorities, and financial institutions to address the issue of NPA
recovery. While these measures vary by country, here are some major steps that have been taken
globally to address NPA recovery:

1. Insolvency and Bankruptcy Code (IBC) and NCLT: In India, the introduction of the Insolvency and
Bankruptcy Code in 2016 and the establishment of the National Company Law Tribunal (NCLT)
streamlined the resolution process for stressed assets. It provided a time-bound mechanism for the
resolution of NPAs and encouraged potential buyers for distressed assets.

2. Asset Quality Review (AQR): Many central banks and regulatory authorities have conducted
comprehensive AQRs to identify and recognize NPAs accurately. This transparency in reporting NPAs
allowed banks to take necessary actions for recovery.

3. Bad Bank Formation: Some countries have considered the creation of "bad banks" or Asset
Reconstruction Companies (ARCs) to take over distressed assets from financial institutions, allowing
them to clean up their balance sheets and focus on their core banking functions.

4. Recapitalization of Banks: Governments and central banks in various countries have infused
capital into banks to improve their financial health and enable them to absorb losses from NPAs. This
enhances the capacity of banks to lend and recover NPAs.

5. Debt Recovery Tribunals (DRTs): In India, Debt Recovery Tribunals have been established to
provide a faster legal mechanism for the recovery of debts. These specialized courts expedite the
NPA resolution process.

Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest

(SARFAESI) Act: The SARFAESI Act in India provides banks with the power to take possession of
collateral and sell assets without the involvement of the court system, expediting the recovery
process.
1. Loan Restructuring Schemes: Various countries have introduced loan restructuring schemes to
provide struggling borrowers with the opportunity to restructure their debt and make it more
manageable, thus reducing the NPA burden.

2. Regulatory Guidelines: Regulatory authorities have issued guidelines and regulations that
encourage prudent lending practices, risk management, and early identification of stressed assets to
prevent the accumulation of NPAs.

3. Auction of Distressed Assets: Banks and financial institutions have conducted auctions to sell NPAs
to asset reconstruction companies or other investors, helping to recover some value from these non-
performing assets.

4. Use of Technology: Digital solutions and data analytics have been increasingly used to identify and
track NPAs and improve recovery efforts. These technologies help in more efficient management of
distressed assets.

5. Enhanced Credit Monitoring: Banks and financial institutions have improved their credit
monitoring and risk assessment systems to identify signs of stress in loan accounts early, allowing for
proactive measures to prevent NPAs.

It's important to note that NPA recovery is an ongoing process, and the effectiveness of these
measures varies by region and economic conditions. The success of NPA recovery efforts also
depends on the legal and regulatory framework, the efficiency of the legal system, and the overall
economic health of a country.

b) How do you differentiate between intentional defaulters and ability defaulters, and
the view of RBI on these two categories of defaulters?

Ans:

Introduction
Non-performing assets (NPAs) have been complex for banks and financial institutions
worldwide. In India, this issue has gained significant attention due to its impact on the
stability and profitability of the banking area.

Concept & Application

Differentiating Between Intentional and Ability Defaulters and RBI's View
The Reserve Bank of India (RBI), like many central banks and financial regulators, differentiates
between two categories of defaulters based on their intentions and their ability to repay. These
categories are commonly referred to as "intentional defaulters" and "ability defaulters." The RBI's
view on these categories of defaulters may influence its policies and actions to address non-
performing assets (NPAs) and bad loans in the banking system. Here's how these two categories
are differentiated:

1. Intentional Defaulters:

• Definition: Intentional defaulters are borrowers who deliberately choose not to repay
their loans, despite having the financial capacity to do so. They may engage in fraudulent
activities, diversion of funds, or wilful default, often with the intent to misuse the funds for
personal gain or to deceive lenders.

• Characteristics:

• These borrowers often exhibit a pattern of dishonesty, evasion, and fraudulent behavior
in their financial dealings.

• They may have siphoned off loan proceeds for personal use, hidden assets, or engaged in
other unethical practices to avoid repayment.

• Intentional defaulters are typically seen as having the ability to pay but lack the
willingness to do so.
• RBI's View: The RBI and other regulatory authorities take a strong stance against
intentional defaulters. They may initiate legal actions, investigations, and enforcement measures
to hold such defaulters accountable. The RBI emphasizes the importance of transparency and
accountability in the financial system and seeks to protect the interests of the banking sector and
the broader economy from fraudulent activities.

2. Ability Defaulters:

• Definition: Ability defaulters are borrowers who face genuine financial hardships, making
it difficult for them to meet their loan repayment obligations. Their default is often a result of
adverse economic conditions, business setbacks, or other circumstances beyond their control.

• Characteristics:

• These borrowers may have a history of timely repayments before facing financial
difficulties.

• Their default is generally due to external factors, such as economic downturns, industry-
specific challenges, or unforeseen events.

• Ability defaulters often express a willingness to repay their debts but may require financial
assistance, restructuring, or relief to do so.
• RBI's View: The RBI recognizes that ability defaulters may require support and leniency to
help them overcome financial challenges and get back on track. The central bank often
encourages banks to engage in resolution and restructuring processes to assist ability defaulters
in repaying their debts. This approach aims to strike a balance between financial prudence and
the need to support borrowers facing temporary financial difficulties.

In summary, the RBI, as a financial regulator, distinguishes between intentional defaulters and
ability defaulters based on the intention and ability to repay loans. The central bank's view is to
take a strong stance against intentional defaulters to maintain the integrity of the financial
system while providing support and resolution mechanisms for those facing genuine financial
hardships. This differentiation is important for the effective management of non-performing
assets and the overall health of the banking sector.