Shyamala Gopinath: Special features of financial sector reforms in India
Inaugural address by Ms Shyamala Gopinath, Deputy Governor of the Reserve Bank of India, at the
18th Annual National Conference of Forex Association of India, Bangkok, 6 April 2007.
* * *
Ms. Nitaya Pibulratanagit, Asst. Governor Bank of Thailand, Mr. Appiah Chairman Forex Association
of India, Mr. Lamba Secretary Forex Association of India, delegates from India and Asia/Middle East,
ladies and gentlemen. It is a pleasure to inaugurate the 18th annual conference of the Forex
Association of India which is affiliated to ACI in this historical city of Bangkok. I understand FIMMDA
had held a similar conference in Bangkok in 2003 which was inaugurated by my senior colleague Dr.
Rakesh Mohan. India and Thailand share a close association dating back to many centuries, which
continues even in the present times, both culturally as well as economically. The past few years have
witnessed increasing economic and commercial links and the signing of a number of Agreements
leading to a further intensification of relations.
The economies of the Asian region are emerging as the new engines of growth in the global economy
and I am sure in this year's conference many speakers will focus on the theme of the conference. For
my address today, I intend to reflect upon the special features of financial sector reforms in India since
the initiation of the reform process in early nineties covering banking sector and financial markets and
certain actions taken and contemplated. There have been innumerable evaluations of the financial
sector reforms undertaken by India, some of which critical of the pace but the results achieved are
acknowledged by all. It is important to understand and appreciate the circumstances under which the
entire process was guided through balancing the given systemic imperatives with the need for bringing
about changes in a non-disruptive manner.
Financial sector reforms in India introduced as a part of the structural adjustment and economic
reforms programme in the early 1990s have had a profound impact on the functioning of the financial
institutions, especially banks. The principal objective of financial sector reforms was to improve the
allocative efficiency of resources, ensure financial stability and maintain confidence in the financial
system by enhancing its soundness and efficiency. At the same time, reforms were also undertaken in
various segments of financial markets, to enable the banking sector to perform its intermediation role
in an efficient manner. With a view to making the reform measures mutually reinforcing, the reform
process was carried forward through analysis and recommendations by various Committees/Working
Groups and extensive consultations with experts and market participants.
I. Special features of the reforms in the financial sector
•
The reforms were not driven by any banking crisis nor were they an outcome of any external
support package. They were undertaken much before the importance of the financial sector
to prevent crisis was recognized by international agencies and other countries in early 1990s
before the Asian financial crisis.
•
The reforms were carefully sequenced in terms of instruments and objectives. Thus,
prudential norms and supervisory strengthening were introduced early in the reform cycle,
followed by interest rate deregulation and gradually lowering of statutory preemptions. The
more complex aspects of legal and accounting measures were ushered in subsequently
when the basic tenets of the reforms were already in place. More recently, the regulatory
framework has also focused on ensuring good governance through "fit and proper" owners,
directors and senior managers of the banks. The preference has been for diversified
ownership.
• While the focus of the first generation of reforms was to create an efficient, productive and
profitable financial services industry, the second phase of financial sector reforms, beginning
from the second-half of the 1990s, was aimed at strengthening of the financial system and
introduction of structural improvements
•
The need to prepare the financial system in a more globalised environment and to promote
financial stability in the face of domestic and external shocks was on top of agenda of
reforms. With increasing globalisation of the Indian economy, the reform process witnessed
a significant move towards adoption of international best practices in several crucial areas of
importance such as prudential norms, banking supervision, data dissemination and
corporate governance.
• With a view to increasing competition in the banking sector new private sector banks were
licensed. A prerequisite for grant of the licence was that these banks had to be fully
automated from day one. The results are self-evident as these banks have become
hightech banks. This has had a "demonstration" effect on the entire system. The Government
ownership in nationalized and State Bank of India was brought down by allowing them to
raise capital from the equity market up to 49/45 per cent of paid-up capital.
•
A unique feature of the reform of public sector banks, which dominated the Indian banking
sector, was the process of financial restructuring. Banks were recapitalised by the
government to meet prudential norms through recapitalisation bonds. The mechanism of
hiving off bad loans to a separate government asset management company was not
considered appropriate in view of the moral hazard. The overhang of non-performing loans
had to be managed by the banks themselves.
•
The subsequent divestment of equity and offer to private shareholders was undertaken
through a public offer and not by sale to strategic investors. Consequently, all the public
sector banks, which issued shares to private shareholders, have been listed on the
exchanges and are subject to the same disclosure and market discipline standards as other
listed entities.
•
The cost of recapitalization to GDP has been low relative to experience in other countries.
On a cumulative basis it worked out to about one percent of the GDP. Furthermore, the
market value of equity held by Government now far exceeds the recapitalization cost. With a
view to carry the reform process further, as announced in the Budget last year the
Government decided to convert the recap bonds issued as special securities (basically
nonnegotiable) to marketable securities indistinguishable from other Government securities .
The process has already started and in 2006-07 the Government converted nearly Rs 80
billion to SLR securities. The balance special securities will be phased out over a period.
• Banks were also allowed to diversify into various financial services and are now offering a
whole range of financial products like universal banks.
•
Active steps were also taken to improve the institutional arrangements, including the legal
framework and technological system. To tackle the issue of high level of non-performing
assets (NPAs), Debt Recovery Tribunals were established consequent to the passing of
Recovery of Debts Due to Banks and Financial Institutions Act, 1993. To provide a
significant impetus to banks to ensure sustained recovery, the Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act
was passed in 2002.
• While transfer of NPAs of public sector banks to separate asset management companies
was not considered, an institutional mechanism to deal with distressed assets of banks and
financial institutions has been created. Asset Reconstruction Companies have been allowed
to be set up which are in the private sector and operate as independent commercial entities
to acquire non-performing assets from any financial entity and restructure and rehabilitate or
liquidate them within a definite time frame. This has created a market for distressed assets in
India.
• The government securities money and forex markets have significant public policy
implications for an emerging market economy. These have developed during the reform
period with impressive diversification of participants and instruments.
•
The smooth functioning of the payment and settlement system is a pre-requisite for financial
stability. The introduction of RTGS and setting up of the CCIL which acts as a central
counterparty for securities and forex transactions and guarantees both the securities and
funds legs of the transaction have enhanced the efficiency of the payments mechanism.
• In terms of the processes also, certain interesting features of the reforms are in evidence.
The first has been its gradualism, wherein reforms were undertaken only after a process of
close and continuous consultation with all stakeholders. This participative process with wider
involvement not only encouraged a more informed evaluation of underlying content of
policies but also enhanced the credibility of policies and generated expectations among
economic agents about the process being enduring in nature.
There has been a constant rebalancing of reform priorities predicated upon the domestic and global
business environment, institution of prudential practices, upgradation of the regulatory and supervisory
framework, institution of appropriate institutional and legal reforms and the state of openness of the
economy.
Impact of reforms in the banking sector
(i) Performance indicators
Various measures initiated over the last decade-and-a half have significantly strengthened the
commercial banking sector in terms of profitability, asset quality and capital position. The soundness
parameters of the banking system, in particular, have shown sustained improvement.
The asset quality of the Indian banking system has improved significantly over the past one decade.
The NPAs of all SCBs, which stood at 15.7 per cent of gross advances and 7.0 per cent of total assets
in 1995-96, declined to 3.3 per cent of gross advances and 1.9 per cent of total assets in 2005-06
(Table 1). Similar trend can also be seen in the net NPAs ratios during the same period, reflecting
better recoveries by banks and better allocation of funds. There has been a distinct improvement in
the recovery climate in recent years facilitated by strong macroeconomic performance and institutional
measures initiated by the Reserve Bank/Government. It is also significant to note that the asset quality
of public sector banks has been better than private sector banks - both old and new - in terms of net
NPL (i.e., net of provisioning).
The financial performance of SCBs had also improved during the recent past as reflected in their
profitability. The operating profit to assets ratio of SCBs, which was 1.69 in 1995-96, increased to 2.03
in 2005-06 (Table 2). Net profit to assets of SCBs remained in the range of 0.47 to 1.13 during the
period 1995-96 to 2005-06. The impact of greater competition and improved efficiency of the Indian
banking system could also be seen from the significant reduction in interest spread over the reform
period.
One of the major objectives of banking sector reforms was to enhance efficiency and productivity
through increased competition. That the competition has intensified could be gauged from the decline
in the share of public sector banks in the total income, expenditure and assets of the commercial
banking system since the mid-1990s, and increase in the share of new private sector banks (Table 3).
Comparison with other countries
Several balance sheet and profitability indicators suggest that the Indian banking sector indicators are
moving towards global benchmarks (Table 4).
(ii) Resolution of NPAs
The Narasimham Committee I had suggested the creation of an Asset Creation Fund to which the
public sector banks would transfer the non-performing assets with certain safeguards. After
deliberations it was decided not to adopt this approach. Instead banks were required to deal with all
the non-performing assets themselves and it is clear from the performance indicators above that this
strategy has been effective. Fiscal support has not been burdensome and legacy problems such as
non-performing loans have been absorbed by banks and not transferred to fisc. Although
subsequently the Government passed a legislation to create a new category of companies called
Asset reconstruction companies, it must be noted that these entities are private commercial entities
and work on a commercial basis to deal with distressed assets. These institutions as well as
guidelines that permit banks to purchase and sell NPAs and the Corporate Debt Restructuring
mechanism have enabled banks to deal with the "flow" and not merely the stock of NPAs. These
measures enable the banks to deal with the NPAs on an ongoing basis.
(iii) Ownership structure
Since public sector banks could divest only by accessing the stock markets except for a few banks all
the others are now listed on the stock exchanges. The Government holding in these banks range from
51 percent (OBC, Dena) to 76 percent (BOM). Of the privately held equity, significant portion (15 to 20
percent) was held by foreign investors in quite a few public sector banks as on 30 September 2006. All
new private banks are listed and there is considerable foreign investment (both FDI and FII) in these
banks. In five of the existing eight banks foreign shareholding had crossed 50 percent. Even among
the old private banks all significant banks are listed.
(iv) Consolidation
The process of consolidation has also been taking place in India. Since 1990, 19 mergers have taken
place in the commercial banking sector. Bank mergers have taken place in India mostly with the
objective to synergise the strength of the merging institutions. Broad guidelines have been laid down
by RBI for mergers for private sector banks from a regulatory and prudential perspective and these
guidelines apply to public sector banks mutatis mutandis and to the extent relevant.
(v) Extension of coverage of reform process
The reform process initially focused on commercial banks. However, after significant progress was
made to transform commercial banks into sound institutions, the reform process was extended to
encompass other institutions such as regional rural banks (RRBs), cooperative banks, All-India
financial institutions (AIFIs) and non-banking financial companies (NBFCs). The regional rural banks,
urban co-operative banks and rural co-operative credit institutions can play a major role in financial
inclusion and deepening of the financial sector, particularly in the rural areas. The co-operative credit
institutions, both urban and rural, are now placed on the path of revival through a consultative method
of policy formulation, ensuring a workable regulatory arrangement to overcome the incentive problems
and financial support wherever necessary. The strategy has started showing results which is crucial
for sustaining their role in financial intermediation among the rural and urban poor and small savers.
Recent initiatives
(i) Supervision of financial conglomerates
Financial conglomerates (FC) pose certain risks to the financial system which could be detrimental to
the overall financial stability. These risks relate to the moral hazard associated with the
"Too-Big-ToFail" position of many financial conglomerates, the fact that financial difficulties in one subsidiary in a
segment could have contagion or reputation effects on another subsidiary in a different segment on
account of the "holding out" phenomenon, especially when using the same brand name, and the
concerns about regulatory arbitrage, non-arm's length dealings, etc. arising out of Intra-group
Transactions & Exposures (ITEs) - both financial and non-financial. The financial sector in India has
undergone significant liberalisation in all the four segments - banking, non-banking finance, securities
and insurance and each of these sectors has grown significantly accompanied by a process of
restructuring among the market intermediaries. The financial landscape is increasingly witnessing (i)
entry of some of the bigger banks into other financial segments like merchant banking, insurance, etc.
which has made them financial "conglomerates"; (ii) emergence of several new players with diversified
presence across major segments and (iii) possibility of some of the non-banking institutions in the
financial sector acquiring large enough proportions to have a systemic impact. In view of the above, a
Working Group had gone into all the issues and had laid down criteria for a group being identified as a
financial conglomerate. Accordingly a system has been put in place for all the identified financial
conglomerates whereby a designated entity within the conglomerate reports to its Lead Regulator. In
order to monitor the intra group transactions and exposures, information from the designated entities
of each FC is obtained by the principal regulators and a system for exchange of information among the
regulators has been put in place. In addition, periodical discussions are held with the CEO of the
designated entity in the FC by the Lead Regulator, along with other regulators, on the basis of
available information for review and addressing concerns, if any. It is also necessary to back-test the
efficacy of the reporting format in capturing the meaningful intra-group transactions/exposures and
other "material" information and also enhance the regulatory understanding of the affairs of the
conglomerates. Further work is being undertaken in this direction in consultation with other regulators.
The inter-regulatory forum has also observed a need for the principal regulator to engage in dialogue
with the principal auditors of the group. This could provide useful information on the impact of changes
in the accounting standards and practices on the core earnings of the conglomerates and the likely
trend in the future. The modalities for this purpose are being worked out in consultation with other
regulators.
(ii) New capital instruments
In Jan 2006, RBI allowed Indian banks to augment their capital funds by issue of innovative perpetual
debt instruments eligible for inclusion as Tier I capital; debt capital instruments eligible for inclusion as
Upper Tier II capital; perpetual non-cumulative preference shares eligible for inclusion as Tier I capital
and redeemable cumulative preference shares eligible for inclusion as Tier II capital. A number of
banks have issued these instruments both in India and overseas to shore up capital
(iii) Procyclical prudential provisioning
Traditionally, banks' loans and advances portfolio is pro-cyclical and tends to grow faster during an
expansionary phase and grows slowly during a recessionary phase. During times of expansion and
accelerated credit growth, there is a tendency to underestimate the level of inherent risk and the
converse holds good during times of recession. This tendency is not effectively addressed by the
ex post
above mentioned prudential specific provisioning requirements since they capture risk but not
ex ante. The various options available for reducing the element of pro-cyclicality include, among
others, adoption of objective methodologies for dynamic provisioning requirements, as is being done
by a few countries, by estimating the requirements over a business cycle rather than a year on the
basis of the riskiness of the assets, establishment of a linkage between the prudential capital
requirements and through-the-cycle ratings instead of point-in-time ratings and establishment of a
flexible loan-to-value (LTV) ratio requirements where the LTV ratio would be directly related to the
movement of asset values.
The above aspect was first taken on board in the Monetary Policy announcement in October 2005 and
since then, various measures have been announced.
In order to ensure that asset quality is maintained in the light of high credit growth, the general
provisioning requirement on standard advances in certain specific sensitive sectors have been
increased as also the risk weights. For instance the risk weight on personal loans (including credit card
receivables) is 125% and the general provision is 2 percent. Similarly the general provisions for real
estate loans is 2 percent and the risk weight 150 percent. The objective is to build cushions or buffers
in upswings without taking a view on the future evolution of asset quality in these asset classes.
(iv) Credit information companies
An efficient credit information system enhances the quality of credit decisions and improves the asset
quality of banks, apart from facilitating faster credit delivery. Accordingly, a scheme for disclosure of
information regarding defaulting borrowers of banks and financial institutions was introduced. In order
to facilitate sharing of information related to credit matters, a Credit Information Bureau (India) Limited
(CIBIL) was set up in 2000. With a view to strengthening the legal mechanism and facilitating credit
information bureaus to collect, process and share credit information on borrowers of banks and FIs,
the Credit Information Act was passed in May 2005. The rules and regulations have also been notified.
The RBI is now framing detailed guidelines on the basis of which it would consider applications from
Credit Information companies. This will facilitate setting up of a few more credit information companies
in India.
(v) Financial inclusion
Recognising the concerns with regard to the banking practices that tend to exclude rather than attract
vast sections of population, the Reserve Bank has urged banks to review their existing practices with a
view to aligning them with the objective of financial inclusion. All banks were advised in November
2005 to make available a basic banking "no-frills" account either with "nil" or very low minimum
balances as well as charges that would make such accounts accessible to vast sections of population.
With a view to encourage financial inclusion the KYC procedure for opening small accounts were
simplified. Banks are allowed to use the services of NGOs/ SHGs, MFIs and CSOs as intermediaries
in providing financial and banking services through the use of business facilitator and correspondents.
Future work program
(i) Draft guidelines on accounting aspects
Recognising the importance of a robust accounting framework in the banking sector, the Reserve
Bank had undertaken an exercise a few years back (in 2001) to assess the gaps in compliance by
banks with the accounting standards issued by the Institute of Chartered Accountants of India. With
the issue of relevant guidelines thereafter, the audited financial statements of banks are found to be in
compliance with the relevant accounting standards. With a view to take things further in this direction,
the Reserve Bank has taken the initiative to introduce the various elements of IAS 39 into the
guidelines for accounting of the investment portfolio and the derivative portfolios of banks. We do not
have a corresponding accounting standard to IAS 39 in India as yet. The ICAI is presently engaged in
the process of issue of this standard and that process is likely to take some more time, hence the
initiative from the Reserve Bank of India. The Reserve Bank has issued draft guidelines on the above
two aspects, which are in the process of finalisation on the basis of the feedback received from banks
and other market players.
(ii) Derivatives - comprehensive guidelines
Derivatives play a critical role in shaping the overall risk profile of banks. Over the years, banks have
been increasingly using derivatives for managing risks and have also been offering these products to
corporates. The Reserve Bank has issued several guidelines to banks from time to time on various
derivative instruments. In view of the growing complexity, diversity and volume of derivatives used by
banks, an Internal Group has been constituted by the Reserve Bank to review the existing guidelines
on derivatives and formulate comprehensive guidelines on derivatives for banks. These guidelines are
intended to cover broad generic principles for undertaking derivative transactions, management of risk
and sound corporate governance requirements. The draft guidelines were placed on the Reserve
Bank's website in December, 2006. The feedback received on the guidelines is being examined by the
Internal Group and the draft guidelines are in the process of finalisation.
(iii) Draft guidelines on stress testing
Risk management practices in banks in India have undergone considerable improvement over the
past few years with the introduction of the financial sector liberalization process in the mid nineties.
The process gained momentum with the issue of regulatory guidelines and guidance notes on asset
liability management and management of credit risk, market risk and operational risk by the Reserve
Bank since 1999. Further, the announcement of implementation of the revised capital adequacy
framework in India with effect from March 31, 2007 has brought the risk management capabilities of
banks into greater focus.
Globally, banks are increasingly relying on statistical models to measure and manage the financial
risks to which they are exposed. These models are gaining credibility because they provide a
framework for identifying, analyzing, measuring, communicating and managing these risks. Since
models cannot incorporate all possible risk outcomes and generally are not capable of capturing
"event risks" and sudden / dramatic changes, banks need to supplement models with "stress tests".
Internationally, stress testing has become an integral part of banks' risk management systems and is
used to evaluate the potential vulnerability to certain unlikely but plausible events or movements in
financial variables. There are broadly two categories of stress tests used in banks viz. sensitivity tests
and scenario tests. These may be used either separately or in conjunction with each other.
Banks in India are beginning to use statistical models to measure and manage risks. Further, the
supervisory review process under Pillar 2 of Basel II framework is intended not only to ensure that
banks have adequate capital to support all the risks in their business, but also to encourage banks to
develop and use better risk management techniques in monitoring and managing their risks. Banks
must demonstrate, under the internal capital adequacy assessment process prescribed by Pillar 2, that
they have enough capital to not only meet the minimum capital requirements but also to withstand a
range of severe but plausible shocks. In the above background, the need for banks in India to adopt
"stress tests" as a risk management tool is being emphasised by RBI.
(iv) Basel II
The Reserve Bank and the commercial banks have been preparing to implement Basel II. The
Reserve Bank had earlier intended in June 2005 that by March 31, 2007 all commercial banks would
comply with Basel II. However, taking into account the state of preparedness of the banking system, it
was decided in October 2006 to provide banks some more time to put in place appropriate systems so
as to ensure full compliance with Basel II. According to the new schedule, foreign banks operating in
India and Indian banks having presence outside India are to migrate to the standardised approach for
credit risk and the basic indicator approach for operational risk under Basel II with effect from March
31, 2008. All other scheduled commercial banks are encouraged to migrate to these approaches
under Basel II in alignment with them but in any case not later than March 31, 2009.
The Basel Committee on Banking Supervision (BCBS) had undertaken the Fifth Quantitative Impact
Study (QIS-5) to assess the impact of adoption of the revised Framework. Eleven Indian banks,
accounting for about 50 per cent of market share (by assets), participated in the QIS-5 exercise. An
empirical analysis indicates that the combined capital adequacy ratio of these banks is expected to
come down by about 100 basis points when these banks apply Basel II norms for standardised
approach for credit risk and basic indicator approach for operational risk. Although none of the banks
which participated in the exercise would be breaching the minimum capital adequacy ratio under the
new framework, the net impact reflects a wide range. The draft guidelines on Basel II implementation
has been placed in public domain but meanwhile RBI has asked the banks to undertake parallel
calculation of the CAR based on the Standardised Approach on a quarterly basis from December 2006
and report it to RBI. These would enable RBI to assess the impact of the revised guidelines and
enable banks to also assess /calibrate the capital requirements.
(v) Mortgage guarantee companies
As announced in the Budget RBI has now placed in public domain draft guidelines on mortgage
guarantee companies. These will be a new category under the NBFC sector and the activities will be
in the nature of mortgage guarantees and not mortgage insurance. Mortgage insurance falls within the
jurisdiction of the Insurance regulator.
(vi) FSAP - self assessment
A Committee on Financial Sector Assessment to undertake a self-assessment of financial sector
stability and development has been constituted. For the purpose of carrying out the task under the
terms of reference, the Committee has decided to set up four Advisory Panels which would be
assisting the Committee in its assessment exercise and would be drawn from non-Official experts in
relevant areas related to financial stability assessment and stress testing, transparency standards,
financial regulation and supervision, and institutions and market structure respectively. To provide
necessary inputs to the Advisory Panels, it has been decided to set up Technical Groups comprising
mainly of Officials directly working in respective areas of regulatory institutions.
Finally a few comments on reforms in financial markets
Well developed financial markets enable the central bank to effectively conduct monetary policy and
help in improving the allocative efficiency of resources. Interest rates on benchmark Government
securities facilitate appropriate pricing of other financial assets. It has, therefore, been the endeavour
of the Reserve Bank to promote development of all the segments of financial market under its
regulatory provision. This is sought to be achieved by easing restrictions on transactions, reducing
transaction costs, increasing the width and depth of the market and introducing trading and settlement
systems in line with international best practices.
In the money market, there has been a significant transformation after the introduction of financial
sector reforms in terms of instruments, participants and technological infrastructure and transparency.
Various reform measures have resulted in a relatively deep liquid and vibrant money market. Further
development of the market depends among others on better ALM practices by banks.
In the Government securities market, several measures have been initiated since 1990s including
guaranteed settlement in respect of all government securities trade through the RBI and I do not want
to go into each of them. However from the fiscal year 2006-07, as per the provisions under the Fiscal
Responsibility and Budget Management (FRBM) Act 2003, the Reserve Bank's participation in the
primary market for Central Government securities stands withdrawn. This has necessitated significant
changes in the setting and operating framework of monetary, debt management and regulatory
policies of the Reserve Bank.
One of the initiatives taken in this regard is broad basing of Primary Dealership system: Till last year,
primary dealer activity was confined to Primary Dealer institutions. In order to broad base the activity,
the structure of Primary Dealership business was expanded to include all Scheduled Commercial
Banks (excluding RRBs), which fulfill certain minimum eligibility criteria. An option was given to the
existing Primary Dealer entities to fold back the PD business into their parent bank or group
companies. Consequently, the configuration of the PD system changed from 17 standalone entities at
the beginning of the year to 8 standalone entities and 10 banks undertaking PD business
departmentally by the end of year 2006-07.
Reserve Bank has been undertaking passive consolidation of securities by reissuing the existing
securities to build up stock at key maturities. During 2006-07, the reissues accounted for 91% of the
total issuances made. Since passive consolidation takes longer time to make an impact on enhancing
the liquidity, Active consolidation was proposed by way of buying back illiqui