R Gandhi: Designing banking regulation in aspiring economies - the
challenges
Keynote address by Mr R Gandhi, Deputy Governor of the Reserve Bank of India, at the
41st Annual Convention of the Department of Business Economics, University of Delhi, New
Delhi, 29 September 2014.
* * *
1. Prof. Suresh Aggarwal, Head of the Department of Business Economics, University of
Delhi, delegates to this flagship 41st Annual Convention of the Department and students
participating in the convention - very good morning! It is an honour for me to be here today
to deliver the inaugural address of the convention. The convention provides a valuable
platform for interaction between the industry and academia on various current issues
relevant to creating conducive business and growth environment. Banking is the backbone to
the development of trade, investments and business in any country and provides crucial
credit and payment infrastructure and services to an economy. In this backdrop, I thought
that it may be appropriate for me to dwell on the main features of the Indian banking
regulatory firmament, specifically, on how the Reserve Bank has tailored its regulatory
stance and the banking regulation framework to suit the evolving needs of the economy and
disparate stages of economic development. My address today, therefore, traces the
evolution of banking regulation in India since independence to highlight the main thought
process behind it as well as the challenges ahead in banking policy formulation.
What and why of banking regulation
2. Banks are special and therefore, exposed to special risks and challenges. In the course of
fulfilling their primary function of financial intermediation they are intricately connected with
various other drivers propelling growth and stability in the real sector. Banks are conduits for
monetary policy transmission and serve as the backbone for credit creation and payments
and settlement systems. Also, banks are highly leveraged institutions and function in
fiduciary capacity. Therefore, the more immediate motivations for banking regulation are the
protection of the depositors' interest and maintaining public confidence in the banking
system. Banking regulations also aim at building efficiency and resilience of the banking
system on the one hand and address the concerns that arise from the functioning of the
financial system. Financial risks are more dynamic than static and assume more intrepid
forms with the evolution of the banking functions, products and financial innovation,
increased functional integration and decentralisation. Contagion and systemic risk, moral
hazard, too big to fail phenomenon, public bailouts of banks are some of the issues that
came under sharp scrutiny following the global financial crisis that erupted in 2008. As such
banking regulation assumes critical significance to retain the resilience and soundness of the
banking entities on the one hand and the macro-prudential stability of the financial system as
a whole on the other and thereby also prevents volatility and disruptions in the real sector
and the overall economy. Then, there are, of course, the structural and developmental issues
relevant to a particular economy and the financial system which, in a large part, provide the
backdrop for the regulatory measures.
3. Banking regulation can take the form of formalised legislation and statutory provisions,
regulatory directions and guidelines, moral suasion, etc. Different times, evolutionary stages
in banking and the various financial and banking crisis have all influenced the regulatory form
and substance from time to time. World over, regulation for the banking sector has gone
through cycles which range from prescriptive to principle based to a less pervasive format
allowing the market mechanism to take precedence (market oriented form of regulation),
from structural restrictions to micro and macro-prudential regulation, etc. As the effectiveness
of traditional control based rules diminishes with increasing competition, liberalization,
globalization and innovation, ongoing regulatory reform assumes great significance. The
recent global financial crisis demonstrated the overwhelming need for evolving
commensurate banking regulation as also the need for the regulatory reform process to
remain ahead of the developments in the banking functions, products and services.
4. I intend to give you a peep into the contextual circumstances that led to the regulatory
measures in the Indian banking sector, as also the rationale for considering these important
reforms and / or changes. While one of the prime thought in this context has always been the
need to align the Indian policy measures and regulatory guidelines with the international best
practices, the different stages of economic growth in the country have had an important
bearing on the regulatory process in the banking sector.
Banking regulation in Emerging Market Economies (EMEs)
5. An emerging market economy (EME) is an economy that has some characteristics of a
developed economy but is not yet a developed economy; it has aspirations to be a
developed economy one day; it has certain distinct characteristics and differs from developed
economies in multifarious ways. An EME is as an economy with low to middle per capita
income with dominance of the proportion of the global population. EMEs are typically
classified as emerging because of the relatively recent initiatives at development and reforms
and beginning to open up their markets and "emerge" on to the global scene. EMEs are
expected to be fast-growing economies; the need for, as also the level of savings,
investments, both domestic and foreign, consumptions and rate of growth are all expected to
be higher and much faster due to the smaller base effect.
6. Accordingly, the EMEs have their specific economic and developmental needs and
agenda. The global banking regulatory standards, or for that matter, the regulatory
framework for any other financial sector segment is designed more to suit the needs and the
level of development in the advanced economies. The fundamental reason for this is their
dominant presence and role in the global standard setting fora as also the more advanced
stages of their financial sector development including the higher level of complexity, variety
and sophistication of financial products and services innovated /offered in these economies.
However, the existing financial intermediaries and the available financial products and
services in the EMEs often fall grossly short of meeting the requirements of higher and faster
growth, savings, investments etc. Moreover, the requirements of funding infrastructure and
social sectors, as also the real sector, are unprecedented, particularly in view of the serious
constraints on funding, muted investor and international confidence, under developed
condition of the social and public institutions, lower levels of appropriate skills, specialisation
and expertise, etc. The risks and volatility emerging from the foregoing are equally large and
often alien to the EME milieu. That is why the regulatory standards, often designed keeping
in view the ground realities in the advanced economies, may not also always be a perfect fit
for the emerging economies and the EMEs use national discretion in this respect while at the
same time making sincere attempts at aligning their regulatory framework with the global
best practices.
Evolution of banking regulation in India
7. Reserve Bank of India was established on April 1, 1935 in accordance with the provisions
of the RBI Act, 1934 (the Act). This marked the culmination of the prolonged efforts, to set up
a central bank in the country. The principle of aligning the regulatory structure to the specific
needs of the country and for that matter to even go beyond the prevalent wisdom and ethos
were distinctly visible at that time itself. Despite the Reserve Bank being constituted as a
central bank, it was thought fit to prescribe in the statute itself a development role for the
Reserve Bank. Accordingly, the Act has a provision that the Reserve Bank will develop and
maintain expertise in agricultural development (later expanded as rural development) and
related subjects and thus began the role of the central bank being sensitive to the need of
the economy.
8. Private banks were then on the scene, though the money lenders were the major source
of funding. A usurious and exploitative system prevailed. As such, after independence in the
year 1947, the Indian banking industry was brought under the regulatory ambit of the
Reserve Bank of India with the passing of the Banking Companies Act in the year 1949.
Later, in March 1966, certain co-operative societies were brought within its fold and this act
was renamed as the Banking Regulation Act, 1949 (BR Act). This enactment brought
significant powers to the Reserve Bank of India (RBI) over the banks. Though anointed as
the regulator, the Reserve Bank was, is and will be conscious of its responsibility to be alive
to the aspirations of the economy.
Promotional and developmental role of the Central Bank in India
9.The basic function of the Reserve Bank, according to the preamble of the Reserve Bank of
India Act, is to regulate the issue of Bank notes and the keeping of the reserves with a view
to maintaining monetary stability in India and generally to operate the currency and credit
system of the country to its advantage. This function imposes on the Reserve Bank the
responsibility for:
• Operating the monetary policy for maintaining price stability and ensuring adequate
financial resources for developmental purposes;
• Promotion of the efficient financial system; and
• Meeting the currency requirement of the public.
10. In the process of discharging these responsibilities, the Reserve Bank over the years
acquired a wide range of promotional and developmental roles. The Government's efforts to
accelerate and sustain growth of the economy through planned development process and to
realize its socio-economic goals also warranted a complimentary role from the Reserve
Bank. The First Five Year Plan emphatically stated, that "central banking in a planned
economy can hardly be confined to the regulation of the overall supply of credit or to a
somewhat negative regulation of the flow of bank credit. It would have to take on a direct
active role of, firstly, in creating or helping to create the machinery needed for financing
developmental activities all over the country and secondly, ensuring that the finance
available flows in the directions intended".
Establishment of specialized institutions
11. In order to meet this mandate that devolved outside the objectives defined in the RBI Act,
1934, in the years of the Five Year plans beginning from 1950-51, the Reserve Bank
embarked upon a number of specialized initiatives. These included establishment of a well
defined structure of credit institutions to promote savings and capital formation and to widen
and deepen flow of agricultural and industrial credit.
12. Apart from furthering the development of cooperatives to provide short-term credit to
agriculture, the Reserve Bank established a separate institution, viz., the National Bank for
Agriculture and Rural Development (NABARD) for provision of medium-term and long-term
refinance for agriculture and rural development as also for providing consultative service to
the Government and banks and generally coordinate its activities in area of agricultural credit
with those of the agencies engaged in purveying such credit. Further, in the absence of an
active capital market, the Reserve Bank actively assisted in setting up of several specialized
financial institutions at all India and also regional level, to widen the facilities for term-finance
to industry and for institutionalization of savings. This included establishment of Industrial
Finance Corporation of India (IFCI), State Financial Corporations, Industrial Development
Bank of India (IDBI) and Unit Trust of India (UTI). In order to provide a safety net for the
small depositors and to encourage commercial banks and other financial institutions to grant
loans to various categories for small borrowers, the Reserve Bank promoted the Deposit
Insurance and Credit Guarantee Corporation of India Limited (DICGC) for providing
insurance and guarantees against the risk of default in payment by the banks or to the
banks.
13. Further, the Reserve Bank also helped establish specialized institutions for specific type
of financing, like National Housing Bank (NHB) and Export Import Bank of India (EXIM
Bank). For ushering in market making in government securities and treasury bills, the
Reserve Bank established the Discount Finance House of India (DFHI) and the Securities
Trading Corporation of India (STCI). The Reserve Bank also helped promote market
infrastructure institutions like the Clearing Corporation of India Ltd (CCIL) and the National
Payment Corporation of India Ltd (NPCI).
Expansion of the scope and reach of the Indian banking system
14. Even though, up to the late 1960's the Indian banking system made reasonable progress,
there were still many rural and semi-urban areas which were not served by banks. The large
industries and the big and established business houses tended to enjoy a major portion of
the credit facilities, to the detriment of the priority sectors such as agriculture, small-scale
industries and exports. Thus, with the primary objective of achieving efficient distribution of
resources in conformity with the requirements of the economy and in order to meet the needs
of the priority sectors, the Government decided to introduce social control over banks by
amending the banking laws. Accordingly, on July 19, 1969 and April 15, 1980 respectively,
14 and six major Indian scheduled commercial banks in the private sector were nationalised.
Social control marked a transitory stage in the evolution of banking policy and in this process;
a system of credit planning and the Lead Bank Scheme were operationalized by the Reserve
Bank to make the banking system function as an instrument of economic and social
development.
15. In conformity with these desired objectives of social control, the banking policy was
reoriented in the seventies for securing a progressive reduction in poverty, concentration of
economic power and regional disparities in the banking facilities. The promotional aspects of
the banking policy came into greater prominence. In this direction, the branch expansion
policy was designed, among other things, as a tool for reducing inter-regional disparities in
banking development, deployment of credit and urban-rural pattern of credit distribution.
Administered interest rate policy emerged as an important instrument for directing the flow of
funds and for augmenting the pace of deposit mobilisation. The Reserve Bank opted for
selective extension of credit under the Selective Credit Control scheme to those sectors that
were accorded priority in conformity with the national objectives. The objective was to correct
undue price fluctuations in respect of certain commodities such as food grains and
agricultural raw materials arising from speculative activities. The main instruments of
Selective Credit Control were a) minimum margins for lending and b) ceilings on the level of
credit against stocks of selected commodities to control the quantum of credit given.
16. The period since 1985 was a process of consolidation which involved, i) comprehensive
action plans by banks covering organization, structure, training, house-keeping, customer
service, credit management and recovery of bank dues, productivity and profitability,
ii) phased introduction of modern technology in banking operations with emphasis on
financial viability by easing some of the policy related constraints on profitability,
iii) strengthening capital base of banks and iv) allowing them flexibility in several areas.
17. By the end of eighties, the Indian economy had developed an extensive financial
superstructure consisting of a vast network of institutions, deploying varied instruments and
facilitating the mobilisation and channelling of funds for working capital and production credit
purposes as well and for long term investment. The Reserve Bank thus helped promote and
nurture a functionally varied and spatially diversified financial system.
Financial sector reforms of 1990s - new economic policy regime
18. In the economic planning phase initiated in April 1951, which postulated financial and
physical controls for rapid economic and social developments, the financial system was
increasingly called on to meet the financial needs of the economy. Commercial banks were
subjected to interest rate controls and regulations such as the pre-emptions in forms of cash
reserves ratio (CRR) and statutory liquidity ratio (SLR), directed lending, prescription of
norms governing credit dispensation. The CRR and SLR that together imposed a marginal
pre-emption of around 28% of bank deposits in 1951, increased to 63.5% in 1991. In
addition, credit allocation at concessional rates at designated priority sectors constituted a
major portion of bank credit and over time, this rose up to 40%.
19. Though the steps initiated post 1951 propelled development of resource mobilisation and
deployment relative to the pre 1951 period, several distortions, rigidities and weaknesses
crept into the financial system which hindered it from playing its role in ushering in a more
efficient and competitive economy. The efficiency, productivity and profitability of the banking
system were severely challenged. Banks became saddled with a large volume of
nonperforming assets. The acceleration in economic growth witnessed in the eighties was also
associated with macro - economic imbalances and persistence of structural rigidities. By
1990, against the background of the weak macro-economic situation with rising inflation, high
fiscal deficit, low economic growth and unsustainable current account deficit, the Gulf war
precipitated the balance of payments crisis. This led to loss of international confidence and
as a consequence international commercial borrowing dried up and non-resident Indian
deposits recorded net capital outflows. The foreign exchange reserves touched a low of US
$1 billion (roughly equal to two week's imports) in June 1991. Besides, by August 1991,
inflation had reached a peak of 17% on annualised basis. These factors coupled together put
pressure on India in meeting its international commitments.
20. The situation called for strong measures towards macro-economic stabilization and
removal of structural rigidities. As a response, an intensive reform programme for developing
a competitive environment as a means of improving productivity and efficiency of both the
economic and financial system was initiated. Deregulation of the real sector and removal of
the license and permit system that was prevalent in and constrained almost all spheres of
production and domestic trade were a part of these initiatives. It was, however, recognized
that the financial sector reform was a necessary concomitant to the trade and industrial
policy liberalization.
21. An overhaul of the Indian financial system was initiated as part of the structural reforms.
In August 1991, the GOI set up a high-powered Committee on the Financial System (CFS)
under the Chairmanship of Shri M. Narasimham, to examine all aspects relating to the
structure, organization, functions and procedures of the financial system and made wide-
ranging recommendations which formed the basis of financial sector reforms relating to
banks, development financial institutions (DFIs) and the capital market in the years to come.
The Committee's recommendations aimed at improving the allocative and functional
efficiency of the banking sector while putting in place a vibrant, diversified, competitive and
efficient system.
22. During the first phase (1991-92 to 1997-98) of reforms, several mutually reinforcing
measures were initiated with focus on strengthening the commercial banking sector by
applying prudential norms, providing operational flexibility and functional autonomy as also
strengthening of the supervisory practices. The important measures undertaken during this
period covered adoption of capital adequacy norms to strengthen the capital base of the
banks, strengthening the IRAC (Income Recognition and Asset Classification) norms to
enable realistic assessment of the asset quality of banks; phased reduction in the SLR and
CRR to augment the lendable resources of banks; rationalization and gradual deregulation of
interest rates for inducing competitiveness; permitting new players in the banking sector to
enhance competition and granting greater flexibility in branch expansion. Another important
aspect of the reforms in this phase was new institutional arrangements like setting up of the
Board for Financial Supervision (BFS) within the Reserve Bank in 1994 for strengthening the
arrangements for monitoring and supervision of banks, especially in view of the increased
risks faced by banks in the liberalized environment; instituting a state of-the-art Off-site
Monitoring and Surveillance (OSMOS) system for banks in 1995 as part of crisis
management framework for Early Warning System (EWS) and as a trigger for on-site
inspections of vulnerable institutions; operationalisation of the Banking Ombudsman Scheme
for expeditious and inexpensive resolution of customer complaints against deficiency in
banking services and compilation and dissemination of credit information so as to contain
incidence of fresh NPAs. Several other channels of NPA management were also instituted
including Lok Adalats, Debt Recovery Tribunals (DRTs), Corporate Debt Restructuring
Mechanism and Asset Reconstruction Companies (ARCs) for strengthening credit appraisal
and recovery framework.
23. The focus in the second phase (1998-99 and beyond) was on further strengthening of
the prudential norms in line with the international best practices, improving credit delivery,
strengthening corporate governance practices, promoting financial inclusion, strengthening
the urban co-operative banking sector and improving the customer service. The experience
of banks facing asset-liability mismatches in the South East Asian countries during 1997,
underlined the need for putting in place sound asset liability management (ALM) practices.
The ALM framework was, therefore, complemented with guidelines on risk management.
One of the significant achievement of this phase was the introduction of comprehensive
policy framework of ownership and governance in private sector banks in February 2005 to
ensure that (i) ultimate ownership and control was well diversified; (ii) directors and CEO and
the important shareholders were 'fit and proper' and observed sound corporate governance
principles; (iii) private sector banks maintained minimum net worth of Rs.300 crore for
optimal operations and for systemic stability; and (iv) policy and processes were transparent
and fair.
Impact of the financial sector reforms
24. The reforms had the desired outcome of strengthening the banking sector; providing
more operational flexibility to banks, enhancing the competitive efficiency, and strengthening
the legal framework governing operations of banks. In addition, the reform measures had a
major impact on the overall efficiency and stability of the banking system in India. The
outreach of the banks increased in terms of branch / ATM presence. The balance sheets and
overall banking business also grew in size. The financial performance of Indian banks
improved, as reflected in their profitability. Following the 1st phase of reforms, the
performance of nationalised banks particularly, showed significant improvement. In the
second phase, the capital position improved significantly and banks were able to bring down
their non-performing assets sharply. As the asset quality began to improve, banks also
started expanding their credit portfolio which included increase in the flow of credit to the
agriculture and SME sectors. Intensified competition however, narrowed down the margins.
But despite this, banks improved their profitability among others, due to increased volumes
and improvement in asset quality. Return on assets improved from 0.39 at the beginning of
reforms in 1991-92 to 0.50 in 2001 -2002. The reform phase also witnessed increased use
of technology which in turn, helped improve the customer service in banks.
25. During the period of reforms, conforming to international standards and best practices
was the primary driver. It is equally true that the economy's difficult situation in the beginning
and the liberalizing, globalising and growing economy also dictated such an approach.
Shift towards macro prudential regulation
26. The reform process did not cease with the second phase of reforms but remained a
progressive ongoing practice in the Indian banking system. The most significant among
these and much applauded in the aftermath of the financial crisis have been the macro
prudential policies. Globally, the financial crisis brought to the fore, only recently, the concept
of macro prudential regulation of the financial system. However, in India along with the
measures detailed in the foregoing paras, there was a gradual shift towards macro prudential
financial regulation as early as 2004 itself. The Reserve Bank made use of the
countercyclical policies since 2004 as a toolkit for addressing systemic risk and ensuring
financial stability though it had used them sporadically even earlier.
27. The instruments used to address the time dimension of the systemic risk have been time
varying risk weights and provisioning norms on standard assets for certain specific sectors
wherein excessive credit growth, in conjunction with sharp rise in asset prices, has caused
apprehension of potential build-up of systemic risk and asset bubbles. In the process, the
policies have "leaned" against the wind and have had the desired effect of moderating the
credit boom in the specified sectors both through signaling effect and affecting the cost of
credit.
28. As regards the cross sectional dimension of the systemic risk which deals with the
interconnectedness issues, various measures have been undertaken such as, prudential
limits on aggregate interbank liabilities; restricting the access of uncollateralized funding
markets only to banks and PDs and stipulating caps on lending and borrowing; restricting the
banks' investments in the capital instruments of other banks; stipulation on banks' exposure
to NBFCs and MFs and close monitoring of systemically important NBFCs and financial
conglomerates; restrictions on unbridled innovation in financial products; enhancing
transparency and addressing risks in OTC transactions by operationalizing reporting
platforms and CCP arrangements.
Current approach to banking regulation and reforms and the challenges involved
29. Given these realities, the needs for the financial sector reforms and regulatory
development in India do not necessarily converge with those felt in the developed nations.
Risks emanating from the EME financial sector are also diametrically different from those
emerging from those in the advanced economies. In the emerging economies, it is the limited
spread of the financial sector as well as the constrained and or underdeveloped / lower
capacity in terms of the products, services and institutions that subject these economies to
various financial risks, as against the advanced economies where the risks emanate from the
sheer scale and volumes of financial transactions, size, connectivity and systemic
importance of the financial institutions, sophistication and complexity of the financial products
and services etc.
30. The need for the financial development and regulatory reform remains as strong as ever
in emerging markets. Instead of innovating complex and sophisticated products and
instruments or setting up financial behemoths, the EMEs require to focus more on the
fundamental financial sector elements such as financial stability, strengthening and creating
sound banking systems, widening the scope and reach of the formal financial system and
services, expanding financial inclusion and enhancing financial literacy, improving monetary
policy transmission as also developing and deepening the financial markets (such as
corporate bond markets and basic currency derivatives) and making them more liquid, etc.
As such the financial development and regulation has to be aligned to these specific needs
of the emerging market economy financial system.
31. One of the most critical aspects of reforms in the Indian financial sector, was the
deliberate strategy of 'cautious gradualism' so that the pace of reforms remained specific to
the nature of the Indian financial system in terms of its maturity, absorptive capacity and the
stage of development and was neither too fast or abrupt to disrupt the very structure of the
financial system nor too slow as not to have a meaningful impact This approach
encompassed small and steady doses of reform push, coupled with a close and continuous
monitoring of impact and preparedness for taking mid-course correction, if required. The
reform measures in the banking sector were coordinated with those in other areas and even
within the banking sector, the measures were well sequenced, with an unwavering focus on
stability.
32. On the one hand, while, since the early years of 2000, the Reserve Bank has embarked
on a dedicated effort at reconciling its guidelines with the Basel Accords and chosen to be
more conservative on many of the prudential norms in comparison to the global standards, it
has also retained its national discretion on some of the regulatory aspects so as not to
disrupt and instead encourage the flow of credit to sectors crucial for growth. Some such
divergences, whether sub-equivalent or super-equivalent, are discussed below:
Capital requirement and leverage ratio
33. RBI implemented Basel III requirements w.e.f. April 1, 2013. Under Basel III too in India,
the minimum capital requirements has been retained at 9% of Risk Weighted Assets as
against Basel III requirements of 8%. Leverage Ratio requirement is proposed to be at 4.5 %
as against Basel III proposal of 3%. In India, the real sector is predominantly dependent on
the banking sector for credit needs. Any disruption in provision of credit supply from banks
may be catastrophic for the economy. Further, the extant external credit ratings provided by
the credit rating agencies to bank loans which determine the risk weight and capital for those
exposures under the Basel II Standardised Approach for credit risk, suffer from various gaps
and weaknesses. In view of the forgoing, it is desirable to reduce probability of bank failures
by having additional capital. The Basel Committee for Banking Supervision (BCBS) provides
flexibility to national regulators to prescribe higher minimum capital requirements. Several
other jurisdictions (e.g. Singapore, China, South Africa, Brazil, Australia etc.) have also
prescribed higher capital requirements than 8% of the risk weighted assets. Incidentally, the
Reserve Bank has prescribed higher capital requirements even under Basle II.
34. However, capital and leverage ratio prescriptions at levels higher than the global
standards can have constraining effect on the supply of adequate credit from banks to the
productive sectors which in turn, can adversely impact growth to some extent raising
questions of trade-off between growth and banking stability. Further, questions have been
raised about requiring banks to mobilise additional capital, given the huge capital needs and
a lackluster capital market. This compels us to take a balanced view about continuing with
the additional requirements to ensure banking resilience by having adequate cushion
towards identified weaknesses and the practical difficulties the banks face.
Exposure norms - the group borrower limits
35. Exposure norms for banks in India are as follows: for a single borrower, it is 15 per cent
of the bank's capital funds and for borrowers belonging to a group, 40 per cent of the bank's
capital funds. The present guidelines also allow banks to exceed the norm with respect to a
single borrower and group borrower by an additional 10 per cent and 15 per cent
respectively, for extension of credit to infrastructure projects and in exceptional
circumstances. Apart from this, there are specific prudential norms for bank finance to
NBFCs, call money / notice money borrowing and lending