Bimal Jalan: Indian Banking and Finance - Managing New Challenges
Speech by Dr Bimal Jalan, Governor of the Reserve Bank of India, at the Banking Economists'
Conference, Kolkata, 14 January 2002.
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Introduction
In my inaugural address last year, I had indicated a vision for Indian banking in the new millennium -
that of a vibrant, internationally active banking system, drawing upon its innate strengths and
comparative advantages to make India a major banking centre of the world. I had pointed out then
that, while it may take up to 10 or even 15 years to achieve this vision, the time to begin was now.
Recent developments have only served to bring forward the urgency attached to embarking upon this
quest. Even as we do so, it is necessary to recognise that, in view of recent global developments and
the economic slowdown, the progress towards this goal would call for even greater effort and
determination. In this context, the theme chosen for this year's Conference i.e., "Indian Banking:
Paradigm Shift" is most timely as it provides an opportunity to deliberate on the new challenges ahead,
and the action that we must take to manage them. I am happy to be a part of these deliberations and
to deliver the inaugural address to the 23rd Conference of Bank Economists here today.
As you are aware, global economic prospects turned sharply adverse since September 2001 following
the terrorist attacks on the US. The possibilities of a recovery in the global economy have become
highly uncertain, belying the initial expectations of a V-shaped recovery as well as the subsequent
hopes of a U-shaped recovery. As of now, the consensus of forecasts settles around 2.4 per cent for
world GDP growth for 2001. World trade volume growth could slow down to around 1.3 per cent and
net capital outflows from developing countries may now be larger than anticipated earlier. Although the
sharp spurt in international oil prices has abated, their future behaviour remains unclear.
Macroeconomic weaknesses have also been associated with an erosion of business confidence.
Insurance, airlines, tourism and hotel industries have been hit hard and the exposure of financial
institutions to these industries can be a potential source of vulnerability.
Despite the relatively inward-looking nature of the Indian economy, it cannot remain insulated from
these international developments. The direct effects of these external developments on our banking
system are expected to be limited. Indirect effects, especially through exports and subdued industrial
activity could, however, impact upon the asset quality of our banking system and other segments of
the financial system. The need to constantly monitor international developments and take appropriate
and often, preemptive action add an entirely new dimension to the progress of our banking system
towards its longer-term vision.
We have made considerable progress in implementing banking and financial sector reforms. There is
also some improvement in the financial performance of the banking system in terms of various
indicators of operating efficiency. Nevertheless, there are several areas regarding the efficiency of our
banking system - rather than its stability - that raise concerns, especially during a period of
generalised uncertainty. The level of non-performing assets (NPAs) continues be high by international
standards, preempting funds for provisioning and eating into the performance and profitability of
financial intermediaries. The response to the debt recovery and asset restructuring initiatives
undertaken as part of financial sector reforms has also been slow.
In the period ahead, our financial system will also have to prepare for a tightening of the prudential
norms as the new Basel Accord becomes effective and a fuller response to the current financial
environment emerges. Our financial institutions continue to be susceptible to financial market
turbulence, especially in the equity market. Upgrading technical skills, technology, research and
human capital, developing effective 'front-office' strategies and fortifying internal rules of governance
and responsibility assumes a renewed priority in the fast changing scenario.
The face of banking, as we have known it, is also changing rapidly. India is approaching an era of
financial conglomorisation and 'bundling' in the provision of financial services. Besides infusing
heightened competition, there are implications for the regulatory and supervisory regime. Banks and
financial institutions have to prepare for changes in the regulatory framework towards a more
focussed, comprehensive and efficient environment that eschews regulatory forbearance. Legal
reforms accordingly will have to ascend the hierarchy of priorities in the reform process.
Against this background, in this talk, I propose to focus on the main challenges facing Indian banking,
such as, the role of financial intermediation in different phases of the business cycle, the emerging
compulsions of the new prudential norms, and benchmarking the Indian financial system against
international standards and best practices. I will also say a few words about the changing context of
regulation and supervision of the financial system in India, the need for introducing new technology in
the banking and financial system, and the importance of strengthening skills and intellectual capital
formation in the banking industry.
Recent Macroeconomic Developments and the Banking System
For a greater part of the twentieth century, the role of the financial system was perceived as mobilising
the massive resource requirements for growth. Since the 1970s and 1980s, development economics
underwent a paradigm shift. The financial system is no longer viewed as a passive mobiliser of funds.
Efficiency in financial intermediation i.e., the ability of financial institutions to intermediate between
savers and investors, to set economic prices for capital and to allocate resources among competing
demands is now emphasised. Developments in endogenous growth theory since the late 1980s
indicate that efficiency in financial intermediation is a source of technical progress to be exploited for
generating increasing returns and sustaining high growth. These changes have provided the rationale
for many developing countries to undertake wide-ranging reforms of their financial systems so as to
prepare them for their true resource allocation function. As important financial intermediaries, banks
have a special role to play in this new dispensation.
The sharp downturn in global macroeconomic prospects and the continuing sluggishness in domestic
industrial activity have necessitated a revision in the forecast for India's real GDP growth in 2001-02
from 6.0-6.5 per cent expected at the time of the April 2001 Monetary and Credit Policy Statement to
5.0-6.0 per cent in the mid-term review of the policy. The downward revision is primarily predicated on
the outlook for the industrial sector which grew by barely 2.2 per cent in April-October 2001 as against
5.9 per cent in the corresponding period of last year, mainly on account of the slowdown in
manufacturing and mining and quarrying. Capital goods production declined by as much as
6.6 per cent and several sectors recorded a slow down in growth rate or an absolute decline. On the
other hand, agriculture sector, supported by reasonable monsoon, recorded a rebound in growth. The
kharif output is expected to cross a new peak of 105.6 million tonnes and prospects for the rabi crop
are also good. On the external front, merchandise exports increased marginally by 0.5 per cent in the
first eight months of 2001-02. While oil imports fell by 13.4 per cent, the non-oil imports showed an
increase of 8.4 per cent. Despite a moderate widening of the trade deficit, continuing buoyancy in net
invisible receipts has kept the current account deficit very low. According to available data, net capital
flows are also likely to be of a higher order than in the preceding year. Foreign exchange reserves
rose to US $ 48.0 billion as on December 28, 2001 recording an accretion of the order of the US $ 5.8
billion over the end-March 2001 level.
In the context of the recent deceleration in the economy the intermediation role assumes even greater
relevance. Banks and financial institutions should endeavour to play a 'supply-leading' rather than
'demand-following' role in initiating the upturn by energising the financial intermediation process. By
virtue of a bird's eye view of the economy and their superior credit assessment of the investment
proposals and the efficiency of capital, banks should endeavour to economise on 'search' costs in
identifying and nurturing growth impulses in the commodity and service producing sectors of the
economy.
In the recent period, monetary policy in India has also moved into a counter-cyclical stance signalled
by cuts in key interest rates and cash reserve requirements. At the same time, market operations have
ensured adequate liquidity to support the revival of aggregate demand with a clear preference for
softening of interest rates within the overall institutional constraints on the interest rate regime. Inflation
has been steadily falling and this has had a positive impact on inflation expectations, along with the
underlying resilience of the macroeconomic fundamentals of the Indian economy. The 50 basis point
reduction in the Bank Rate and the 200 basis point reduction in the CRR, announced recently, are
expected to significantly enhance the lendable resources of the banking system.
The current situation of comfortable liquidity provides an opportunity for banks to transform idle
liquidity into investible resources for growth. The easy interest rate environment would make it
possible for banks to 'price in' projects which would have earlier remained unfunded due to inherently
lower returns to capital or due to lack of access to prime lending rates. This will, however, require
reassessment of portfolios and internal liquidity constraints, even adjustments in risk profiles and risk
management. The deceleration in the industrial growth scenario, of course, opens up the moral hazard
of adverse selection and the possibilities of large-scale contamination of portfolios. In a situation of
generalised slowdown, unviable projects can look potentially bankable given the scarcity of investment
avenues.
Nevertheless, the possibilities for financial intermediation in the current situation are too varied and
challenging to ignore. There is no systematic evidence that financial sector reforms by themselves and
without supportive policies in other areas, can contribute to a revival of the economy; yet this is a time
when the responsibility on the financial system to contribute to the process of economic revival is
greater than before. Periods of downturn in economic activity also provide opportunities for banks to
undertake consolidation and strengthening. There is a strong complementarity between financial
stability and macroeconomic stability. The interests of both are served by a stable and resilient
financial system.
In recent years, various measures have been taken to improve the functioning of different segments of
the financial markets and thereby, to improve the operational effectiveness of monetary policy. The
Liquidity Adjustment Facility (LAF), which was introduced in June 2000 has emerged as an effective
and flexible instrument for managing liquidity on a day-to-day basis. In the second stage of the LAF,
which commenced from May 2001, variable rate repo auctions replaced the collateralised lending
facility and Level I support to primary dealers. Standing facilities were rationalised and a back-stop
facility was introduced at variable market-related rates. Concurrently, LAF operating procedures were
recast to improve operational flexibility and complementary measures were undertaken to improve the
functioning of money and government securities market segments and to facilitate their orderly
integration.
In order to enable the call money market to evolve into a pure inter-bank market, lending by non-banks
was reduced to 85 per cent of their average daily call lending in 2000-01 from May 2001. The
minimum maturity for wholesale term deposits of Rs.15 lakh and above has been reduced to 7 days
from the earlier minimum maturity of 15 days. The maintenance of daily minimum cash reserve
requirements has been lowered to 50 per cent from 65 per cent for the first seven days of the reporting
fortnight. Interest paid on eligible balances under CRR has been raised to the level of the Bank Rate
from November 3, 2001. The market has responded positively with an appreciable rise in turnover and
a decline in volatility.
Several measures have also been taken to improve the functioning of the government securities
market. 14-day and 182-day Treasury Bills were withdrawn and the notified amounts of 91-day
Treasury Bills has been simultaneously increased. A Negotiated Dealing System (NDS) is being
introduced to facilitate electronic bidding and to disseminate information on trades on a real-time
basis. For this purpose, the Reserve Bank has begun the automation of its public debt offices. An
important step is the setting up of the Clearing Corporation of India Ltd. (CCIL) to act as counterparty
in all trades involving government securities, Treasury Bills, repos and foreign exchange. The entire
system will operate in a networked environment and INdian FInancial NETwork (INFINET) will provide
the backbone for communication.
Prudential Norms
A strong and resilient financial system and the orderly evolution of financial markets are key
prerequisites for financial stability and economic progress. In keeping with the vision of an
internationally competitive and sound banking system, deepening and broadening of prudential norms
to the best internationally recognised standards have been the core of our approach to financial sector
reforms. This has been supported concurrently by heightened market discipline, pro-active and
comprehensive supervision of the financial system and the orderly development of financial market
segments. The calibration of the convergence with international standards is conditioned by the
specific realities of our situation; however, the New Capital Accord of the Basel Committee on Banking
Supervision which was released in January 2001 adds urgency to the process of convergence. It is
against the backdrop of these exigencies that prudential norms are being constantly monitored and
refined. In the recent period, banks are being encouraged to build risk-weighted components of their
subsidiaries into their own balance sheets and to assign additional capital. Risk weights are being
constantly refined to take into recognition additional sources of risk. The concept of 'past due' in the
identification of NPAs has been dispensed with. Banks and financial institutions are being urged to
prepare to move to the international practice of the '90 day norm' in the classification of assets as
non-performing by 2003-04.
The new Basel Accord, as contained in the second Consultative Paper on Capital Adequacy of the
Basel Committee on Banking Supervision released in January 2001 is in response to the perceived
rigidities in the 1988 Accord's capital requirements, the scope for capital arbitrage and the increased
sophistication in the measurement and management of risk. The new Accord rests on three mutually
reinforcing pillars i.e., minimum capital requirements, processes of supervisory review and market
discipline. Under the first pillar, the current definition of capital and the minimum requirement of 8 per
cent of capital to risk weighted assets is retained. Capital requirements would be extended on a
consolidated basis to holding companies of banking groups.
The primary emphasis of the new Accord is on improving the measurement of risk. The process of
measurement of market risk is maintained. Three alternatives for calculating credit risk capital
requirements are proposed to be made available to banks, depending on the complexity of their
business and the quality of their risk management operations. The 'standardised approach' which can
be employed by less complex banks remains conceptually the same as in the 1988 norms; however, it
expands the scale of risk weights and uses external credit ratings to categorise credits. Banks with
more advanced risk management capabilities can employ an internal ratings based (IRB) approach -
'foundation' and 'advanced' variants are proposed on a progression scale - in which banks may
categorise exposures into multiple credit ratings of their approved internal rating systems. The
internally estimated probability of default, the maturity of exposure and the credit type i.e., corporate or
retail, will determine risk weights. There is a new explicit capital charge proposed on operational risk.
The processes of supervisory review contained in the second pillar emphasise the need for banks to
develop sound internal procedures to assess the adequacy of capital based on a thorough evaluation
of its risk profile and control environment, and to set commensurate targets for capital. The internal
processes would be subject to supervisory evaluation, review and intervention, when appropriate. The
third pillar aims at bolstering market discipline through enhanced disclosure by banks. Disclosure
requirements are set out in several areas under the new Accord, including the way in which banks
calculate their capital adequacy and their risk assessment methods.
The Basel Committee on Banking Supervision has received more than 250 comments on the January
2001 proposals. The Committee is expected to release a fully specified proposal, based on these
comments, in early 2002 and to finalise the Accord during 2002. An implementation date of 2005 is
envisaged. The Reserve Bank forwarded its comments to the Basel committee in May 2001. It has
supported flexibility, discretion to national supervisors and a phased approach in implementing the
Accord. The Accord could initially apply to internationally active - banks with over 15 per cent of their
business in cross-border transactions, as proposed by the Reserve Bank - and significant banks
whose domestic market share exceeds 1 per cent - with a simplified standardised approach to be
evolved for other banks. Material limits on cross-holdings of capital and eschewing of direct
responsibility on external credit rating agencies in the assessment of bank assets have also been
proposed by the Reserve Bank. It has also expressed its preference for external credit rating agencies
that publicly disclose risk scores, rating processes and methodologies.
The new accord, when implemented, is likely to have significant implications for the banking system as
a whole. Besides requiring increased capital, it attaches urgency to the development of efficient and
comprehensive internal systems for assessment and management of risks, setting up and adhering to
adequate internal exposure limits and improving internal control generally. The guidelines for risk
management and asset liability management provided by the Reserve Bank serve as a useful
foundation for building more sophisticated control systems. The feedback received from few banks
indicates the need for substantial upgradation of existing management information systems, risk
management practices and technical skills. Capital allocation is also expected to be more risk
sensitive and, therefore, banks and financial institutions will have to plan in advance so that there are
no disruptions in the capital structure. Further sophistication in risk management and control
mechanisms will have to evolve as experience with preferential risk-weighting and sensitivity to
external ratings is accumulated.
A key requirement when the new Accord, after further modification, becomes operational is that of high
quality human resources to cope with and adapt to the new environment. Enhancing technical skills
and abilities to handle new technologies and new risks, exploiting information flows to price them in,
and developing foresight in anticipating changing risk-return relationships will become essential.
Market Discipline
Processes of transparency and market disclosure of critical information describing the risk profile,
capital structure and capital adequacy are assuming increasing importance in the emerging
environment. Besides making banks more accountable and responsive to better-informed investors,
these processes enable banks to strike the right balance between risks and rewards and to improve
the access to markets. Improvements in market discipline also call for greater coordination between
banks and regulators.
India has been a participant in the international initiatives to ensure improved processes of market
discipline that are being worked out in several fora, such as, the multilateral organisations, the BIS, the
Financial Stability Forum, and the Core Principles Liaison Group. Concurrent efforts are underway to
refine and upgrade financial information monitoring and flow, data dissemination and data
warehousing. Banks are currently required to disclose in their balance sheets information on maturity
profiles of assets and liabilities, lending to sensitive sectors, movements in NPAs, besides providing
information on capital, provisions, shareholdings of the government, value of investments in India and
abroad, and other operating and profitability indicators. Financial institutions are also required to meet
these disclosure norms. Banks also have to disclose their total investments made in equity shares,
units of mutual funds, bonds and debentures, and aggregate advances against shares in their notes to
balance sheets.
From this year onwards, notes to banks' balance sheets will disclose the movement of provisions
against NPAs as well as those held towards depreciation on investments. Guidelines relating to
non-SLR investments through the private placement route mandate the disclosure of information on
issuer composition and non-performing investments in a similar manner. Efforts have been made to
identify and monitor early warning indicators of financial crises. The overall approach is to combine the
use of micro-prudential indicators with macro-economic indicators in order to develop a set of
aggregate macro-prudential indicators. This brings about a mix between bottom-up and top-down
assessment. As the methodology gets refined and the indicators are stress-tested for predictive
power, financial stability surveillance will be significantly improved. This process will involve greater
transparency and objectivity in the disclosure practices of banks.
Efforts have also been made to set up a Credit Information Bureau to collect and share information on
borrowers and improve the credit appraisal of banks and financial institutions within the ambit of the
existing legislation. The Bureau has been incorporated by the State Bank of India in collaboration with
Housing Development Finance Corporation (HDFC) and foreign technology partners. Collection and
sharing of some items of information have already been initiated. Efforts are also going into the
collection and sharing of information on private placement of debt under the Bureau so that there is
greater transparency in such trades. The possibility of collecting and disseminating information on
suit-filed accounts by the Bureau (in place of the Reserve Bank) is being explored by a Working Group
constituted for this purpose with representation from across the financial system. The Group will also
examine the prospects of on-line supply of information and the processing of queries. A draft
legislation covering various aspects of information sharing, including issues relating to rights,
responsibilities, and privacy has been prepared, which would considerably strengthen the functioning
of the Bureau when it is enacted.
Benchmarking the Indian Banking System by International Standards
The impetus given to the strengthening of domestic financial systems and the international financial
architecture by the Asian crisis has gathered momentum in recent years. An important development in
this regard has been the move to set up universally acceptable standards and codes for benchmarking
domestic financial systems. Moreover, multilateral assessments of country performance are
increasingly focusing on observance of standards. The IMF's Article IV consultations, its Financial
Sector Stability Assessment and the Reports on Observance of Standards and Codes of the IMF and
the World Bank are indicative of the fact that a country's adherence to benchmark standards and
codes is being considered integral to the preservation of international monetary and financial stability.
While the process has begun with the predominant involvement of governments and regulators, the
search for standards and codes is progressively encompassing the private sector with consideration of
issues relating to market discipline, corporate governance, insolvency procedures and credit rights.
It is important to recognise that new standards and codes are not being regarded as final goals but as
instruments or enabling conditions for enhancing efficiency in financial intermediation while ensuring
financial stability. There are three levels at which action is necessary, viz., legal, policy and
procedures, and market practices by participants. In several areas, fundamental changes in the legal
and institutional infrastructure are pre-requisites. Since these changes can impinge upon the
socio-cultural as well as politico-economic ethos, appropriate adoption and some prioritisation in
implementation are unavoidable.
We have made some noteworthy progress in generating a constructive debate on the applicability of
international standards and codes to the Indian financial system. Participative consultation has been
supported by internal self-assessments as well as external assessment. In several areas, the issues
are of a technical nature. Accordingly, the Standing Committee on International Standards and Codes,
set up in December 1999, constituted ten Advisory Groups comprising eminent experts, generally
nonofficial, to bring objectivity and experience into studying the applicability of relevant international codes
and standards to each area of competence.
The Advisory Groups have submitted their reports. They have set out a roadmap for implementation of
appropriate standard and codes in the light of existing levels of compliance, the cross-country
experience, and the existing legal and institutional infrastructure. The Advisory Group on Banking
Supervision has assessed the Indian banking system vis-à-vis the principles of the Basel Committee
on Banking Supervision. It has found the level of compliance to be generally of a high order. The
Advisory Group on Bankruptcy Laws has, inter alia, recommended a comprehensive bankruptcy code
incorporating various aspects including cross-border insolvency and the repeal of the Sick Industrial
Companies Act. The Advisory Group on Corporate Governance has made recommendations relating
to rules and responsibilities of boards and has advised amendments to the Companies Act.
The Advisory Group on Data Dissemination has found that India's data dissemination compares
favourably with many other countries and has proposed the compilation of forward-looking indicators.
The Advisory Group on Fiscal Transparency is of the view that current fiscal practices meet the IMF's
Code of Good Practices on Fiscal Transparency. It has recommended amplifying the scope of fiscal
responsibility legislation in order to include the essential elements of a budget law. The Advisory
Group on Insurance regulation has recommended flexible minimum capital requirements depending
on the class of business. With regard to actuarial and solvency issues, the Group has found the Indian
standards to be at par with international norms. The Advisory Group on International Accounting and
Auditing Standards has set out an agenda for the future for convergence in auditing and accounting
practices. It has recommended a single standard setting authority and the need for convergence of
corporate and tax laws.
The Advisory Group on Transparency in Monetary and Financial Policies has recommended inflation
as the single mandated objective for the central bank and necessary autonomy to fulfill the mandate. It
has also made recommendations on the operating procedures of monetary policy. The Advisory Group
on Payments and Settlement has recommended legal reforms to empower the Reserve Bank to
supervise the payment and settlement system, application of the Lamfalussy standards to deferred net
settlement (DNS) and introduction of Real Time Gross Settlement (RTGS). It has also recommended
the setting up of the Clearing Corporation and a separate guarantee fund for foreign exchange
clearing. The Advisory Group on Securities Market Regulation has compared India against the
International Organisation of Securities Commissions (IOSCO) principles and emphasised the need to
strengthen inter-regulator cooperation.
Thus, in India, we have made considerable progress in the identification of international standards and
codes in relevant areas, expert assessment regarding their applicability, including comparator country
evaluation and building up possible course of action for the future. The next step is to sensitise all
concerned - policy makers, regulators and market participants - to the issues involved and to seek the
widest possible debate on issues as well as expert assessments with a view to generating a broad
consensus on implementation of a universally recognised set of codes and standards.
Universal Banking
Since the early 1990s, banking systems worldwide have been going through a rapid transformation.
Mergers, amalgamations and acquisitions have been undertaken on a large scale in order to gain size
and to focus more sharply on competitive strengths. This consolidation has produced financial
conglomerates that are expected to maximise economies of scale and scope by 'bundling' the
production of financial services. The general trend has been towards downstream universal banking
where banks have undertaken traditionally non-banking activities such as investment banking,
insurance, mortgage financing, securitisation, and particularly, insurance. Upstream linkages, where
non-banks undertake banking business, are also on the increase. The global experience can be
segregated into broadly three models. There is the Swedish or Hong Kong type model in which the
banking corporate engages in in-house activities associated with banking. In Germany and the UK,
certain types of activities are required to be carried out by separate subsidiaries. In the US type model,
there is a holding company structure and separately capitalised subsidiaries.
In India, the first impulses for a more diversified financial intermediation were witnessed in the 1980s
and 1990s when banks were allowed to undertake leasing, investment banking, mutual funds,
factoring, hire-purchase activities through separate subsidiaries. By the mid-1990s, all restrictions on
project financing were removed and banks were allowed to undertake several activities in-house. In
the recent period, the focus is on Development Financial Institutions (DFIs), which have been allowed
to set up banking subsidiaries and to enter the insurance business along with banks. DFIs were also
allowed to undertake working capital financing and to raise short-term funds within limits. It was the
Narasimham Committee II Report (1998) which suggested that the DFIs should convert themselves
into banks or non-bank financial companies, and this conversion was endorsed by the Khan Working
Group (1998). The Reserve Bank's Discussion Paper (1999) and the feedback thereon indicated the
desirability of universal banking from the point of view of efficiency of resource use, but it also
emphasised the need to take into account factors such as the status of reforms, the state of
preparedness of the institutions, and a viable transition path while moving in the desired direction.
Accordingly, the mid-term review of monetary and credit policy, October 1999 and the annual policy
statements of April 2000 and April 2001 enunciated the broad approach to universal banking and the
Reserve Bank's circular of April 2001 set out the operational and regulatory aspects of conversion of
DFIs into universal banks. The need to proceed with planning and foresight is necessary for several
reasons. The move towards universal banking would not provide a panacea