Mr Jalan looks towards a more vibrant banking system.  (Central Bank Articles and Speeches, 16 Dec 1998)
Central bank: rbi | Type: speech | Date: 1998-12-16

## Mr Jalan looks towards a more vibrant banking systemInaugural address by the Governor of the Reserve Bank of India, Mr Bimal Jalan, to th Bank Economists [apostrophe?]Conference (BECON'98) held at Bangalore on 16/12/1998.

## IntroductionI am happy to join this special gathering of bankers and deliver the inaugural addr conference of bank economists .

This year's meeting of bank economists is particularly impor as it is being held against the background of one of the worst meltdowns of the financ experienced by a number of economies.The recent financial market developments show that we have come to live in a wor considerable uncertainty, where prudence and foresight get rewarded while errors, in judgements and bad decisions impose severe costs on the individual financial interme well as on the financial system as a whole.

In today's liberalised financial environme investors and financial intermediaries are widely dispersed, not necessarily confined t boundaries.

This has made capital extremely fluid and highly sensitive to polic performance of the financial systems of the recipient countries.

Pursuing policies an that ensure improved efficiency and continued stability of the financial system has critical importance in the present context of a more open world economy.In India, over the past few years, we have made substantial progress towards improv performance of our financial system and putting in place a new financial regime which r on detailed controls and directions and more on initiative, autonomy in decision-mak accountability.

Policy initiatives since 1992 in this regard have been directed at buil and ensuring the safety and stability of the financial system.

Compared with the expe many developing countries embarking on financial sector reform, we have trodden caut and in an orderly fashion, which has helped us in minimising the adjustment costs inv the process.

This, however, should not lead to any complacency, particularly in the con present fluidity of international capital markets and the increased vulnerability of economies to sharp fluctuations in macroeconomic situations.

These disturbances tend exaggerated if the financial system is fragile and lacks depth in absorbing internal shocks.It is important to note that the number and frequency of bank failures in the world hav rapidly in recent years.

These failures have occurred both in countries which followed more open policies as well as the ones exercising control in different degrees.

Recent in East Asia and elsewhere have brought to fore the criticality of a financial system's ensuring sustainability of openness in invigorating economic growth.

In one important also marks a departure from the excessive emphasis laid on the proposition that liberalisation per se will lead to higher growth.

While developing financial institution markets is important for growth, it may not, however, prove sufficient to provide outcomes if the safeguard systems are not very sound and the financial system is unstablIt is in the above context that the theme of this year's bank economists' conference, strengthen the Indian financial system, assumes critical importance.

Indeed this is a most developing countries at present.

Many of them have initiated a fresh round of s reforms in their financial systems.

A number of international agencies, including theI would like to acknowledge with thanks the help of Shri M.S.

Mohanty and Shri Partha Ray of the Reserve India in the preparation of this lecture.International Settlements (BIS), are also currently engaged in identifying factors th vulnerability of financial systems and devising new safety standards that would help stability.

In India, the second Report of the Narasimham Committee has recently addr number of vital issues pertaining to the health and stability of the financial system a that is necessary to strengthen it.

Some of these recommendations have been implemented recent monetary and credit policy announcements.As professional bankers and economists, you are no doubt seized of the challenges that developments in international financial markets have posed for the Indian financial sys has been our experience of financial reforms so far?

Where do we stand in terms of stability considerations?

What are the tasks ahead if the Indian financial system is to competitive strength substantially and strengthen itself to withstand the pressures of What role should the bank economists be playing in this environment?

Let me try and ad few of these issues in my remarks this morning.

## A Review of DirectionsThe significance of the financial system for an economy arises from at least three major s First,

it performs various transformation functions relating to intermediation of f economy.

Secondly, it provides the mirror image of the underlying real economy and th macroeconomic balances.

Thirdly, it is one industry whose basis of operation is underp public trust.

The strength of this bond between the banking system and people in genera on how the financial viability of the banking system is perceived.

The organisation an of financial markets should be such that they reflect the underlying fundamentals economy.

The financial system as a whole must remain sound and stable in order to enjoy level of public confidence.Until recently, the improvement in various transformation functions of the financial s the focal point of reform initiatives in many developing countries.

The basic issue w create a competitive environment for the financial system and to put in place a poli which would lead to improved allocative efficiency of the financial sector and enhanc saving and investment activities of the economy for attaining faster rates of economic financial markets developed and matured, the two-way interaction between the financi nonfinancial policies grew in importance.

In the recent years, the increased market e the financial system and its vulnerability to macroeconomic shocks have highlighted the greater internal controls and the need for strengthening prudential norms and regulati environment of rising importance of cross border capital flows, perceptions and expe play major roles in shaping events and this consideration can be particularly heighte financial system is perceived to be weak and unsound.

It is not surprising that finan initiatives globally have now moved to the strategic considerations of ensuring c stability of the financial system.In India, since the formal announcement of the first initiative of financial sector r Union budget of 1991-92 to the Second Report of the Narasimham Committee in 1998 considerable ground has been covered in putting in place a financial system which can requirements of a more competitive and open economy.

By and large, financial reforms i have proceeded in four major directions.First, setting the policy conditions right and removing the operational constraints of system.

What the reform process has tried to achieve is to lower the share of pr resources in the total resources of the banking system through gradual liberalisationreserve ratio and the statutory liquidity ratio.

While the medium term target of 25% an for the CRR and SLR, respectively, have been, by and large, achieved, these ratio level higher than what would perhaps look ideal in the international context.

Our relati reliance on the cash reserve ratio has been necessitated by the needs of monetar operations.

As financial markets develop, allowing for a greater role for the interes economy, the dependence on this instrument of monetary policy would need to come down future.The second directional change has been in the area of creating a more competitive envi in the financial sector through reform measures such as relaxation of entry and ex reduction in public ownership in the banking industry and letting banks access the capi in order to meet their funding requirements.

The objective is to bring out the best re of pricing and quality of banking services over a period of time.The third important direction of reform has been the strengthening of market institu allowing greater freedom to financial intermediaries.

These reforms have taken the gradual liberalisation of interest rates, development of money, capital and debt ma giving operational flexibility to banks in the management of their assets and liabiliti course, to prudential guidelines.

In simple terms, these changes imply a greater exposure of individual financial institutions to the domestic and international environment.In this connection, a distinction needs to be made between two types of market develo which have implications for the financial system.

One is developments in resp macroeconomic fundamentals of the economy which impact on the interest rate, exchange and other asset prices.

This is a normal phenomenon in any economy and has implications balance sheets of the financial intermediaries.

Institutions which do not have an approach in anticipating events, undertaking pre-emptive actions and designing a response to unanticipated developments can find themselves in a difficult situation, p in times of a large degree of fluctuations in macroeconomic variables.

The dangers p market and credit risks arising out of macroeconomic shocks need to be given special at a liberalised financial system.

Our reform initiatives in this area are still in the The second type of market developments which have implications for the financial sector to asset price bubbles, which may be related to a high concentration of bank lending two sectors which have a boom and bust cycle of their own.

This form of market exposure unhealthy and lead to irreparable shocks.

Although the impact of such cycles on our system is quite limited, international experience suggests that, unless prudential mea place, banks can be potentially vulnerable to asset price pressures that can generat risks for the financial system.The fourth important element of reform concerns the 'safety' aspects of the financia This is the core of the challenges facing the financial system at present.

When the ref was started in 1992, there was a massive problem of cleaning the balance sheets of ban had deteriorated over the years.

Successive reform initiatives in this area have bee prescribing certain prudential standards for the financial system and addressing certai weaknesses which could minimise their recurrence in future.

Measures such as in recognition norms, asset classification, meeting minimum capital adequacy standards recapitalisation and devising a supervisory framework are steps in the direction of en safety of the financial system.

## Where Do We Stand?The

key indicators of banking sector performance during the past few years mark noticeable changes.

For example, the net profit of the scheduled commercial banks percentage of their total assets has been turned around from a negative figure of -1 average during 1992-93 and 1993-94 to a positive of 0.5% during 1994-95 to 1997-98.

I case of most public sector banks, business per employee and profit per employee have improvement in the recent period.

Certain other indicators also look good.

By 1997, a public sector banks had achieved the minimum capital adequacy norm of 8%.

The gross an non-performing assets of the banking system as a percentage of advances declined to 1 8.2%, respectively, by March 1998.

In terms of percentage to total assets, gross and performing assets declined to 7.0% and 3.3%, respectively, by March 1998.I think the present statistics are not unfavourable for the banking system as a who second report of the Narasimham Committee has observed, 'this improvement has arreste deterioration in these parameters that had marked the functioning of the system earlier in view the current macro economic and international financial situation, the Commit noted that:'There is still, however, a considerable distance to traverse.

The process of streng banking system has to be viewed as a continuing one.

There is no finite end to impro levels of efficiency and profitability.

In fact, the situation is one where the syste constantly with changes in the broader environment in which it functions and fac challenges that these developments impose on it' (p. 18).The banking sector indicators in India need to be seen against the backdrop of i vulnerability of the financial systems of developing countries and the need for imp efficiency and stability.

The Narasimham Committee has presented a detailed analysis of problems and challenges facing the Indian banking system and made wide-rangi recommendations for improving and strengthening its functions.

Let me shortlist a few k which must concern us at this stage.The Indian banking system is still perceived as a relatively high cost banking.

This is the relatively high operating cost of the banking system.

A comparative analysis indi while the average operating cost of banks as a percentage of assets was about 2.3% during 1990-91 to 1995-96, it was 1.1% in China, 1.6% in Malaysia, 1.9% in Thailand, 1.

Japan and 2.1% in G10 Europe.

One of the major problems posed by a relatively intermediation cost in our case is that it gives rise to uneconomical banking.

It necessity of maintaining a relatively high interest income spread and a high real le This adversely affects financial intermediation and growth in the economy.Operating costs depend on labour productivity, technology, innovation and organis effectiveness of a bank to harness various static and dynamic economies from the pro process.

On the economy-wide scale, these factors differentiate the weak from the stron system and provide internal strength and stability to the system.

Without gaining advantage in this respect, it is difficult to think of a significant improvement in system in future.A key issue relates to the banking sector's non-performing assets (NPAs).

The amount o and net NPAs have been on the rise, although the rate of their growth has been below th rate of expansion of advances.

Apart from absolute size, the distribution of non-passets is skewed across banks.

Still a large number of public sector banks have performing assets ranging between 10 to 20% of net advances.

The Narasimham Committee underlined the need to reduce the average level of net NPAs for all banks to 3% by 200 zero for banks with international presence.

I think this is an important requireme banking system and is crucial to maintaining the viability of the system in future.

A t strategy identified by the Committee viz., to reduce the backlog NPAs and improv management efficiency and stricter enforcement of prudential norms, has to be acted upon with this challenge.Another critical aspect is the soundness of the banking system and how this is reflec practices and principles followed by banks.

Prudential norms and supervision are neces they are no substitute for the internal control system and sound business practices.

Th distinguish between a normal business risk and an abnormal one, managing such risk defining a prudent limit for risks are essential functions for the bankers.

For a long banking did not have a tradition of dealing with various forms of market risks.

The cr of managing such risks has now come into the open, especially against the experience recent East Asian crisis, where markets fell precipitously because banks and corporate accurately measure the risk spread that should have been reflected in their lending act did they manage such risks or provide for them in their balance sheets.

In India, t Bank has recently issued comprehensive guidelines to banks for putting in place an asse management system.

Formal guidelines will be issued shortly in the light of suggestions from banks.

But, ultimately risk management is a culture that has to develop from wi internal management systems of the banks.

Its critical importance will come into sha once current restrictions on banks' portfolios are further liberalised and are subj pressure of macro economic fluctuations.While developing a system of internal control and risk management is of critical impor the banking system, there is no escaping the fact that a permanent improvement in the Indian banking is not possible without addressing the long-term structural weaknesse system.

Our banking system operates with a large continent-wide network of branches, scale economies in the banking industry are limited, owing to the fragmented organi structure.

Today, size is becoming increasingly important for strategic business planni sphere of the economy.

The banking sector is no exception.

When competition is the key is the market structure and regulation that need careful attention.

Furthermore, given tier financial system of our economy, and the complementarity and synergetic relation these different tiers, it is difficult to isolate the efficiency of the banking system long-term financial institutions, cooperatives, rural banks and non-bank financial com more meaningful reorientation of objectives and functions of various tiers of institutions would be necessary in dealing with the long-term issue of enhanc competitiveness of the system as a whole.

It is also important to ensure that the structure of Indian banks is such that managerial decision-making is not affected economic considerations, and banks are able to raise sufficient capital in line increasing volume of business.Another crucial issue, especially in the present context, relates to banks' special rol delivery system.

There is no inherent conflict between the canons of sound banking and proactive role in credit disbursements to promote growth.

These two objective complementary to each other.

High growth leads to high credit off-take and credit av conditions influence growth prospects of an economy.

Ultimately, it is the credit busi is central to the profitability of the banking system.

To the extent that excessiveamong bankers restricts credit growth in the economy, it has adverse effects on the pr of the banking system as well as on economic growth.Credit disbursement to the rural sector and small-scale industries require special att banks.

The Gupta Committee recommendations involving greater flexibility and discretion lending banks in the agricultural sector in matters of collateral, margin, securi certificate, composite cash credit limits etc., have to be implemented by the banks exp Similarly, special treatment has to be accorded to small-sector units in improv accessibility to institutional finance with a view to enabling them to emerge as profi the banking system.

Given its critical importance in the manufacturing and export act the economy, it is unlikely that the banking system's profitability and efficiency without exploiting the opportunity provided by the small-scale industrial sector.

T Committee has recently made a comprehensive set of recommendations for improving the cr delivery system for small-scale industries, which are being implemented in phases.

## The International ContextAn important effect of the Asian economic crisis, and of the recent developments in J been

that there is now a much greater international focus on the soundness of the banking system in all countries - developed and developing.

Unlike previous financial c persistent crisis in the real economy in East Asia and also Japan is generally belie been accentuated by the weakness in the financial sector rather than the other way r health of the banking sector and the prudential and regulatory framework are thus no matter of domestic concern only.

A country's ability to access capital markets as investments abroad is likely to depend on whether the domestic financial system is per broadly conform to international prudential and supervisory norms.

In fact, the world themselves are being put to a severe test by the changing nature and ramifications o crises in several parts of the world.

What were earlier considered to be the ideal prud for preventing individual bank failures have been proved to be severely inadequate to systemic instability or prevent the contagion effects.In various international fora, an intensive effort is now underway to evaluate the exi and practices being followed by banking systems in different countries and to assess these norms have helped or prevented instability in the banking system.

India has b participating in these discussions and is helping in the formulation of norms and which take into account the views of the developing countries, where market structu growth objectives are different than in industrial countries.

Issues currently und include: the corporate governance system in banks, risk management, banking regulati supervision, transparency and accountability and public policies relating to moral banking sector.

The Basle Core Principles for Effective Banking Supervision have underlined the need to adhere to 25 basic principles for adopting an effective supervision syste aftermath of the East Asian crisis.

More detailed work is now in progress after t publication of three reports by the Willard Group, constituted by the Bank for Int Settlements, on enhancing transparency and accountability, strengthening financial sys managing international financial crises.The Willard Group reports have argued for improving the credibility and accountabilit banking system through more transparent accounting practices and better disclosure norm have drawn attention to the need to develop a stable and efficient financial syste strengthening the corporate governance system and risk and liquidity management among and putting in place a proper safety net arrangement for the banking system.

They hargued for a more organised approach in preventing international financial crises an orderly system of creditor and debtor coordination and effective solvency laws.The recent international consensus on preserving the soundness of the banking system ha around certain core themes.

These are:

effective risk management systems, adequate provision, sound practices of supervision and regulation, transparency of operation, public policy intervention and maintenance of macroeconomic stability in the economy.An important issue which we, along with other countries, would need to address is how t that individual banks govern themselves according to the best practices in corporate go This, as mentioned before, involves according utmost importance to prudent business pr such as developing an effective internal control system, monitoring and managing the range of financial and commercial risks, and instituting a proper system of asset an management in order to avoid term mismatches in portfolios.

A proper cushion needs to by way of capital reserves against market exposure and capital size should set a limit exposure of an individual financial institution.

Apart from capital adequacy standard international norms of banking regulation and supervision require a more proactive rol regulator in enforcing an effective mechanism for evaluating, monitoring and managing the financial system.

This in turn would need stricter accounting, valuation and repor on the part of banks.The Basle core principles have also identified a number of challenging areas for regu supervisors, which must be satisfied to ensure orderly conduct of financial syste promote its soundness and stability.

Transparency in banking operation is also somethi has to receive top priority given the current nature of capital markets.

Transpa accountability demand realistic valuation of assets, public disclosure norms and p reporting by banks to help depositors and investors form an informed opinion about the the financial system, thereby enabling them to react in an orderly fashion to asset pr Moreover, public intervention policies in the form of explicit or implicit guarantees be such that they do not lead to 'moral hazard' in the form of undue risk-taking by b laxity in observing market disciplines.India must remain in the forefront of the movement for ensuring soundness of the b system by adopting best practices and best international standards of performance and p Actions have already been initiated in this direction.

The challenge now is to acce process so that the banking and the financial system in our country can contribut sustained growth of the real economy with price stability.

## Role of Bank EconomistsBefore I conclude, let me say a word about the role of Bank economists in facilitating process.

This annual conference is a testimony to the economic talent that our bankin has developed over the years.

Almost all our banks have economic research departmen economic cells which are staffed by highly qualified economists with long experience in and the financial sector.

The issue that I would like to pose before this conference making the best and most effective use of economists working in the banking sector to the functioning of banks, and for that matter, the operational efficiency of the finan a whole?

In commercial organisations like banks, economics departments have the advant not being excessively burdened with day-to-day problems of running the banks or ensur safety and profitability of individual transactions.

They are in a position to take longer-term view of the comparative or competitive advantage of their individual banksas identify areas of portfolio weaknesses and the costs/benefits of various kinds of s products offered by them.

They also have the opportunity to study from their vantage p from a practical angle the working of the financial system and various improvements ne strengthen the financial intermediation function.However, for bank economists to be able to perform these functions, it seems tha reorientation of the role that is assigned to them is necessary.

There is also a ne 'attitudinal' change on the part of economists themselves.

Those who work in the comm banking sector have to be prepared to accept operational responsibility, to work in th to familiarise themselves fully with the commercial aspects of their bank's work.

Their to be operationally relevant, and it must contribute to the financial soundness operations.

This is possible if bank economists also have branch-level experience and e of working in non-economic departments with line responsibility.At present, the role of economists in our banking sector seems to be too narrowly defi are viewed as keepers of data, particularly macroeconomic data, and undertake periodic or analysis of macroeconomic trends in the economy.

They are seldom involved in undert any operational work or in developing strategic policy choices or even in treasury exchange functions.

All over the world, with deregulation and globalisation of the sector, the role of economists in the banking sector has been changing and becoming m more focussed on the analysis and valuation of the risk associated with various alt particularly in emerging economies that are subject to greater volatility in the financ India, however, the role of economists has been somewhat slow in changing.It may perhaps be useful for this conference to initiate a process of discussion on issues and to reassess the role that members of this distinguished body can play i forward the process of reform in our country.

The challenges ahead are gigantic, but th exciting.

Given the determination, I have no doubt that India can have one of the mos financial systems in the world.I would like to acknowledge with thanks the help of Shri M.

S.

Mohanty and Shri Partha the Reserve Bank of India in the preparation of this lecture.