Mr Talwar considers emerging trends in supervision in India
Central bank: rbi | Type: speech | Date: 1999-01-30

## Mr Talwar considers emerging trends in supervision in IndiaSpeech by Mr S P Talwar, a Deputy Governor of the Reserve Bank of India, at the meeti SAARC Supervisors in Pune (India) on 27-30/1/99.At the outset, on behalf of the Governor of the Reserve Bank of India and Government of extend a hearty welcome to all the Central Bankers of the SAARC Region on their visit and particularly to the Reserve Bank's College of Agricultural Banking.

I also feel ho the privilege bestowed on me to inaugurate the Meeting of the Bank Supervisors to 'Emerging Trends in Supervision' today.It is in fitness of things that the Meeting is being held in this city, which is known learning' in and around which great Indian philosophers and educationalists held s centuries.

The scenic surroundings of the College of Agricultural Banking and salubriou of Pune, I am sure, will provide the necessary ambience for sharing the inherent su skills and learning about each other's country experiences.The theme of discussions of such inter central bank meets used to centre around core e or monetary policy issues.

However, in the context of the South East Asian financial its contagion effect on the financial system of some of the even well establish economies, regulation and supervision of financial vehicles has emerged as the foremost concerns in any international conference.

Central banks around the world have also working towards strengthening prudential norms and enforcing transparency in fin reporting by financial institutions to avert any future international financial crisis.The regulatory and supervisory frameworks for banks and other institutions in India h undergone significant changes, keeping pace with the reforms introduced in the financi The details of these changes will be presented in greater detail by my colleagues from the coming sessions.

I would like to highlight some of the more important ones to se backdrop for the fruitful discussions that are slated to follow this inaugural session.

## Prudential NormsThe focus of the statutory regulation of commercial banks in India until the early mainly

on licensing, administration of minimum capital requirements, pricing of s including administration of interest rates on deposits as well as credit, reserves and requirements.

In these circumstances, the supervision had to focus essentially on solvenAfter the evolution of the BIS prudential norms in 1988, the RBI took a series of me realign its supervisory and regulatory standards almost on a par with international bes At the same time, it also took care to keep in view the socio-economic conditions of th the business practices, payment systems prevalent in the country and the predominantly nature of the economy, and ensured that the prudential norms were applied over the pe across different segments of the financial sector in a phased manner.

The Indian banki is at present subjected to the following prudential norms:

## Exposure Norms- Exposure to a single borrower should not exceed 25% of the bank's capital funds (i.e capital and free reserves).- Group exposure should not exceed 50% of the capital funds of the bank.

An additiona is allowed in respect of exposure to infrastructure projects (power, telecom, roads

## Connected Lending- Section

20 of the Banking Regulation Act prohibits loans to directors or to any company in which directors hold an interest.- The banks should maintain an arms-length relationship in respect of own subsidiaries ventures; all loans to such companies have to be made at commercial rates and are su limits which apply to similar companies.- There is an aggregate ceiling fixed for loans related to owned funds of the subsidiar

## Capital Adequacy Norms- Under the risk-weighted asset approach for the purpose of capital adequacy standar minimum

CRAR has been prescribed at 8% and will be further raised, to 9% (which already applicable to banks permitted to trade in gold), with effect from 31 March 20

## Income Recognition Norms- Under the Income Recognition Norms, income from non-performing assets cannot be tak as part of the profits of banks unless the income has been realised.

## Asset Classification Standards- The definition of 'past due' for a period of any two quarters in a financial year i interest or instalment of principal under a credit facility has been adopted as part Classification Norms to identify NPAs.- Based

on the status of an asset as an NPA, it is required to be classified as substandard, doubtful and loss assets and appropriate provisions made.- Banks are required to make a general provision of 10% of the total outstanding substandard assets.- A doubtful asset has been defined as one which has remained as an NPA for a p exceeding 2 years and provisions are required at 100% of the unsecured portion and 50% in respect of the secured portion over a period of 3 years.

The period for rec NPA as doubtful will be further shortened, to 18 months, by 31 March 2001.- Banks are required to write off the entire loss assets or make 100% provision theref- Banks are required to create provisions on government guaranteed NPAs from 1 April 20- A general provision of 0.25% on standard assets has to be made for the year ending 3 2000.

## Marking Investments to Market- Banks

are required to bifurcate their investments in approved securities (govt. guaranteed securities and bonds) into "permanent" and "current" investments.

The r permanent investment to total investment has been reduced from a high of 70% in 1992 30% in 1998-99 and the intention to mark 100% of bank's investments to market (as c investments) over the next 3 years has already been announced.

While appreciation value of securities is ignored, depreciation has to be fully provided for.The aforesaid prudential standards compare favourably with some of the internation practices already in vogue in developed economies.

## New Supervisory InitiativesThe entire supervisory mechanism has been realigned since 1994 under the directions of constituted Board for Financial Supervision (BFS), which functions under the aegis of to suit the demanding needs of a strong and stable financial system.

The supervisory j of the BFS now extends to the entire financial system barring the capital market insti the insurance sector.The periodical on-site inspections, and also the targeted appraisals by the Reserve Ban supplemented by off-site surveillance which particularly focuses on the risk profi supervised institution.

A process of rating of banks on the basis of CAMELS in respect banks and CACS (Capital, Asset Quality, Compliance and Systems & Control) in respec foreign banks has been put in place from this year.The Off-site Monitoring and Surveillance System (OSMOS) was introduced in 1995 as additional tool for supervision of commercial banks to supplement the on-site examinati system consists of 12 returns (called DSB returns) focussing on supervisory concerns capital adequacy, asset quality, large credits and concentrations, connected lending, e risk exposures (viz. currency, liquidity and interest rate risks).

As part of the f returns have so far been operationalised and the second tranche of returns on risk ma aspects and consolidated supervision is expected to be introduced by next year.The supervisory intervention by the RBI is normally triggered by the deterioration in t capital adequacy, NPAs, credit concentration, lower earnings, and larger incidence o which reflect the quality of control.

## Internal Control SystemsLike the central banks in developed supervisory regimes, the RBI also has started pl increasing reliance on professional accountants in the assessment of internal control the banks and non-bank financial institutions.

Over the period, the responsibilities have been delineated not only to make the audit more detailed but also to make accountable.

The methodology and processes used to generate available data as certifie audit profession would improve the reliability of financial statements as regards their with national accounting and disclosure standards.Another area of crucial importance is the strengthening of internal control systems in Reserve Bank has, over the years, emphasised the need for having an effective interna system in banks.

Banks have also been advised to introduce the system of concurrentmajor and specialized branches.

As a result, all commercial banks have introduced co audit since 1993 by using external auditors as a major resource.

The banks are now re set up audit committees to follow up on the reports of the statutory auditors and inspe RBI.

Similarly, immediate action is warranted on reconciliation of inter branch accoun if left unreconciled, are fraught with grave risks.

Substantial progress has been made reconciliation of the outstanding entries, and the BFS reviews progress in this area intervals.

## Operational Strength of the Indian Banking SystemIt is now commonly acknowledged that the Indian banking sector has, as a result of the reforms, emerged strong and resilient.

The public sector banks which suffered losses of crore in 1992-93 and Rs.4,349 crore in 1993-94, i.e.

in the initial years of intr prudential norms, have ended the year 1997-98 with a net profit of Rs.5027 crore.

Net public sector banks formed 8.2% of the net advances and 3.3% of the total assets as at March 1998.

## Evolution of the Risk Management SystemFinancial institutions carry a wide range of risks, including credit, interest rate, fo liquidity, operational and reputational risks.

These risks are highly interdependent (whether expected or unanticipated) that affect one area of risk can have ramification risk categories.

In the context of deregulation of interest rates in India, market emerged as an area requiring immediate attention on the asset side of the balance recognition of this, the RBI has issued to the banks draft guidelines (with the fina becoming operational from 1 April 1999) for a broad framework for asset-liability mana taking into account the variance in the business profile of banks in the public sector sector as well as the data/information base available to banks in India.

## Transparency and Disclosure StandardsAnother area where the RBI has moved ahead is to impart greater transparency to the sheets of banks.

This was a logical step after the adoption of prudential norms, with t India coming under greater international scrutiny.

During the last couple of years, th extent of disclosures has been gradually increasing so as to provide a clearer picture readers of balance sheets.

The banks are now required to disclose the break-up of the made towards NPAs, depreciation of investments and other purposes besides, the c adequacy ratio and the level of net non-performing assets.With effect from 1997-98, banks are required to disclose accounting ratios relating heads like operating profit, return on assets, business per employee and profit per From the year ending 31 March 2000, the following information, among others, should a disclosed by the banks operating in India in the published accounts:- Maturity pattern of loans and advances, investment securities, deposits & borrowings,- Foreign currency assets and liabilities,- Movements in NPAs & provisions,- Lending to sensitive sectors as defined by the RBI from time to time.The primary objective of any supervisory regime has to be prudential, viz., to protect and soundness of domestic banking systems.

Its application can at the same time pro incentive for other countries to improve the quality of their prudential supervision.

I to operate in other markets where these core principles are strictly applied, they w convince the authorities in the host countries that the quality of supervision in their is adequate.

This can create powerful new incentives for improvements in supervision.

R I had the privilege of associating myself with the Willard Group of the Bank for Int Settlements (BIS) constituted by G 10 countries to look into these aspects.

The Group out with recommendations which call for close coordination amongst central banks governments of the world, as well as the international financial institutions like t World Bank, in promoting stability, accountability and transparency in the financial sys

## Adoption of Core Principles and Uniform Accounting StandardsThe Core Principles for Effective Banking Supervision (1997) evolved by the Basle Comm on

Banking Supervision (BCBS) have been accepted for adoption by the RBI.

The Co Principles seek to promote and enhance the standards of supervision.

Incidentally, I ma the International Accounting Standards Committee (IASC) is also working closely wit BCBS on reducing differences in supervisory approaches to loan valuation and credi provisioning.

In many areas of banking supervision and securities regulation, inte consensus has been reached and principles or standards have been established.

In oth there still is a need to define best practices and develop standards.

The lack of consensus on sound practices for loan valuation, loan-loss provisioning and credit risk seriously impairs the ability of market analysts as well as regulators to understand an risk inherent in a financial institution's activities.

## Supervision of Non Bank Financial InstitutionsI would like to specifically mention the far-reaching supervisory initiatives on the pa which has now brought all Indian development finance institutions and non banking fi companies under an intensive supervisory framework through both on-site inspection and monitoring procedures.

## Development Finance InstitutionsThe RBI set up an exclusive Supervisory Division in August 1990 for monitoring the ope of

select all Indian development financial institutions (FIs).

Currently, 12 such FI monitored.

Of them, the term lending and refinance institutions, viz.

Industrial De Bank of India (IDBI), Industrial Credit & Investment Corporation of India Ltd. (ICICI), Finance Corporation of India Ltd. (IFCI), Industrial Investment Bank of India Ltd. (IIB Bank, Tourism Finance Corporation of India Ltd. (TFCI), National Bank for Agricultur Rural Development (NABARD), National Housing Bank (NHB) and Small Industries Development Bank of India (SIDBI) are also subject to the on-site supervision proces RBI.Prudential norms relating to income recognition, asset classification, provisioning adequacy have also been prescribed, for IDBI, ICICI, IIBI and EXIM Bank in March 1994 for SIDBI , NABARD and NHB in March 1996.

## Supervision of NBFCsThe RBI has been regulating the NBFCs, which numbered around 40000 companies, for over decades since 1963.

The regulatory role up to 1997 was confined to deposit acceptance a of NBFCs and did not cover the asset quality and liquidity mismatch aspects.In the context of the increasing functional diversity and expanding intermediation r sector, the RBI, through enabling legislation to its regulatory powers, has taken a se for compulsory registration and liquidation of recalcitrant and defaulting companies in of public deposits.

An entry norm of minimum net owned funds of Rs.25 lakhs was presc for the purpose of registration.A registration process to cover as many as 7689 companies was initiated in July 1997 completed by December 1998.

Simultaneously, prudential guidelines have been put in pl govern the various aspects of their functioning besides bringing them under more inten site supervision based on the CAMELS pattern.

More detailed presentation on some o innovative supervisory practices and extensive use of technology for data compilat analysis is slated to follow during the last session of this Meeting.

## Millennium (Year 2000) IssuesI would like draw your attention to one of the current IT related issues, viz. the Y2 which is pursued by the RBI more as a business continuity risk than a technology probl initiation of supervisory measures by the RBI is in synchronisation with the standards BIS.

The RBI has an enlarged role of monitoring and enforcing compliance by the financial sector and co-ordinates its efforts with the National Level Task Force set Prime Minister of India.Major policy initiatives taken in this regard focus on promoting increased awa establishing targets and benchmarks for industry, industry-wide status assessme maintaining pro-active supervisory pressures.

The RBI issued circulars in September commercial banks explaining the Y2K problems and possible solutions.

Targetted on appraisals have been commissioned by the RBI to verify the compliance efforts on the banks.A target date of 31 December 1998 was fixed for ensuring Y2K compliance and banks may subject to penal measures in case of persisting non-compliance beyond March 1999.

Inst have also been advised to put in place appropriate contingency plans to take care o system failures.

A high-powered Working Group in the RBI, under the chairmanship of Deputy Governor and with representatives drawn also from the banking industry, revie progress made in compliance at regular intervals.As you would have observed from the foregoing, the Indian supervisory system has already much headway in realigning itself to the emerging needs, particularly addressing t inherent in the liberalisation and globalisation of the Indian economy after the advent sector reforms.

The prudential norms adopted by Indian banks in the area of marki investments to market conform to the international standards.

The disclosure norms prescribed for Indian banks as part of accounting standards do conform to the glo practices besides ensuring transparency in published accounts.

The only area where standards are yet to be implemented in full are those relating to asset classification in respect of re-defining NPAs as those past due for a quarter (instead of 2 quarters aand the reduction in the period for classifying such accounts as doubtful from 24 mon months.

We are however making earnest efforts in this direction to make our banking more transparent and vibrant.The banking system had acquired, at the time of introduction of prudential norms for time in 1992-93, a large quantum of non-performing credit which can be termed as legacy It is worth mentioning that the incremental NPAs in subsequent years have been at much levels.

The level of NPAs in the Indian banking sector is being commented upon as an a one by various international and domestic analysts/groups.

At the same time, these agen rather chosen to ignore the high level of NPAs which have totally eroded the banking sy the East Asian countries, with many banking institutions folding up as a consequence background, it has to be mentioned that the NPAs of the Indian banking system have a been provided for more than 50 per cent, which is often ignored by the international when evaluating the NPA status of the Indian system.

Further, Indian banks secure their a very large extent by collateral.

The banks in India do not normally prefer to writ covered by collateral during the pendency of cases in law courts.

Looking into the realisation of collateral, it is of paramount need to focus our attention on expediting recommended by the Committee on Banking Sector Reforms (Narasimham Committee II).

The banks also have to activate the procedures of compromise settlements and their r machinery towards faster recovery.Another factor which contributed to the build-up of NPAs in the past was the lack of attention on the end use of funds by the borrowers.

The borrowers in many instances w projects and purposes other than those included or prioritised in the original schemes by the banks.

To avoid such a situation, the banks have already started paying a lot of the end use of credit.

The RBI expects the banks to set up an efficient and approp review mechanism for this purpose.As you would have observed from the foregoing, we have covered a lot of ground strengthening our prudential regulation and supervision system for the financial syste last few years.

I can proudly claim that the efforts of the central bank in this d helped in sustaining the health of the Indian banking system, enabling it to with contagion effect of the East Asian syndrome.There is a lot of pressure to reduce the asset classification norm to one quarter in r due loans and a lot of discussions have taken place in this regard at various intern However, we have taken a view that the international practices should not be merely m but should be carefully evaluated and applied to a country's specific situation, keepi the support systems.

In countries like India and even in some well developed countries, and commerce cycle combined with payment and settlement systems extends beyond a quart Unless the underlying commercial and payment systems move towards faster settlement of transactions, we do not see any immediate compulsion to shift to a norm for asset clas of one quarter in respect of past dues.I should stress at this point that it is easy to introduce stricter norms but it discipline to resist leeways sought by banks at the implementation stage.

We are not in such leniencies.

We strongly believe that once the norms are laid by the central bank, be complied with in letter and spirit by the constituent institutions.

Though it has time for us to introduce the prudential norms, I am sure that the banks in India fo norms as a gospel.I would like to conclude with a request to the participating financial supervisors to deliberations and try to arrive at possible ways of addressing emerging areas of s concern which are not just regional but universal, owing to the interdependency of systems across the globe.

I shall particularly like the supervisors' discussions to cent assessment of supervised institutions' capabilities in the management of NPAs, in appropriate business and operational risk management systems, enhancing transparen disclosure standards and earnestness in the introduction of an effective intern mechanism.I would like to record my appreciation for the excellent arrangements made by the Co Agricultural Banking and untiring efforts on the part of its Principal, Mr S K Newla colleagues in hosting the Meeting.

I am sure that no efforts will be spared by the team after the comforts of the visiting dignitaries from other central banks during their st