V Leeladhar: Indian financial sector reforms
Address by Mr V Leeladhar, Deputy Governor of the Reserve Bank of India, at the Annual Washington
Conference of the Institute of International Bankers, Washington, DC, 5 March 2007.
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Introduction
At the outset, I am thankful to the Institute of International Bankers for giving me this opportunity of
addressing the Annual Washington Conference 2007.
The banking system in India has undergone significant changes during last 15 years. There have been
new banks, new instruments, new windows, new opportunities and, along with all this, new challenges.
While deregulation has opened up new vistas for banks to augment revenues, it has also entailed
greater competition and consequently greater risks. The traditional face of banks as mere financial
intermediaries has since altered and risk management has emerged as the defining attribute.
Financial sector reforms introduced in the early 1990s as a part of the structural reforms have touched
upon almost all aspects of banking operations. For a few decades preceding the onset of banking and
financial sector reforms in India, banks operated in an environment that was heavily regulated and
characterised by sufficient barriers to entry, which protected them against too much competition. This
regulated environment set in complacency in the manner in which banks operated and responded to
the customer needs. The administered interest rate structure, both on the liability and the assets sides,
allowed banks to earn reasonable spread without much efforts. Despite this, however, banks'
profitability was low and NPLs level was high, reflecting lack of efficiency. Although banks operated
under regulatory constraints in the form of statutory holding of Government securities (statutory
liquidity ratio or SLR) and the cash reserve ratio (CRR) and lacked functional autonomy and
operational efficiency, the fact was that most banks did not operate efficiently.
While the broad objectives of the financial sector reforms, thus, were to enhance efficiency and
productivity, the process of reforms were initiated in a gradual and properly sequenced manner so as
to have a reinforcing effect. The approach has been to consistently upgrade the financial sector by
adopting the international best practices through a consultative process. Financial sector reforms were
carried out in two phases. The first phase of reforms was aimed at creating productive and profitable
financial institutions operating within the environment of operational flexibility and functional autonomy.
The focus of the second phase of financial sector reforms starting from the second-half of 1990s has
been on strengthening of the financial system consistent with the movement towards global integration
of financial services.
Financial sector reforms in India
The deregulation of interest rates constituted an integral part of financial sector reforms. The interest
rate regime has been largely deregulated with a view to achieving better price discovery and efficient
resource allocation. Banks now have flexibility to decide their deposit and lending rate structures and
manage their assets and liabilities accordingly. At present, apart from interest rates on savings
deposits and NRI deposits on the deposit side, and export credit and small loans up to Rs. 2 lakh on
the lending side, all other interest rates have been deregulated.
Indian banking system operated for a long time with high reserve requirements both in the form of
Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). This was mainly to accommodate the
high fiscal deficit and its monetisation. The efforts in the recent period have been to lower both the
CRR and SLR. The SLR has been gradually reduced from a peak of 38.5 per cent to 25 per cent. The
CRR was reduced from its peak level of 15.0 per cent maintained during 1989 to 1992 to 4.5 per cent
of NDTL in June 2003. Although the Reserve Bank continues to pursue its medium-term objective of
reducing the CRR, in recent years, on a review of macroeconomic and monetary conditions, the CRR
has been revised upwards to 6.0 per cent (to be effective from March 3, 2007).
It has been the endeavour of the Reserve Bank to establish an enabling regulatory framework with
prompt and effective supervision, and development of legal, technological and institutional
infrastructure. Persistent efforts, therefore, have been made towards adoption of international
benchmarks, as appropriate to Indian conditions. In 1994, a Board for Financial Supervision (BFS)
was constituted comprising select members of the Reserve Bank Board with a variety of professional
expertise to exercise 'undivided attention to supervision' and ensure an integrated approach to
supervision of commercial banks and financial institutions. The Reserve Bank had instituted a state
ofthe-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. The scope and coverage of off-site surveillance has since been widened to
capture various facets of efficiency and risk management of banks.
As a part of the financial sector reforms, the regulatory norms with respect to capital adequacy,
income recognition, asset classification and provisioning have progressively moved towards
convergence with the international best practices. These measures have enhanced transparency of
the balance sheet of the banks and infused accountability in their functioning. Besides sub-standard
assets, provisioning has also been introduced for the standard assets. Measures to reduce the levels
of NPAs concentrated on improved risk management practices and greater recovery efforts facilitated
by the enactment of Securitisation and Reconstruction of Financial Assets and Enforcement of
Security Interest (SARFAESI) Act, 2002. Several other channels of NPA management have also been
Lok Adalats
instituted, including Debt Recovery Tribunals, (People's court) and corporate debt
restructuring mechanism with separate schemes for small and medium industries.
The minimum capital to risk assets ratio (CRAR), which was earlier stipulated at eight per cent was
revised to 9 per cent in 1999, which is one percentage point above the international norm. As some
banks in the public sector were not able to comply with the CRAR stipulations, there was a need to
recapitalise them to augment their capital base. Banks were allowed to raise capital from the market.
In line with the amendment to incorporate market risk in Basel I, separate capital charge for market
risk was also introduced in 2004.
Accounting standards and disclosure norms were strengthened with a view to improving governance
and bringing them in alignment with the international norms. The disclosure requirements broadly
covered capital adequacy, asset quality, maturity distribution of select items of assets and liabilities,
profitability, country risk exposure, risk exposures in derivatives, segment reporting, and related party
disclosures. In April 2005, commercial banks were advised to put in place business continuity
measures, including a robust information risk management system within a fixed time frame.
In view of the increasing degree of deregulation and exposure of banks to various types of risks, the
Reserve Bank initiated measures for further strengthening and fine-tuning risk management systems
in banks. The guidelines on asset-liability management and risk management systems in banks were
issued in 1999 and Guidance Notes on Credit Risk Management and Market Risk Management in
October 2002 and the Guidance Note on Operational risk management in 2005. In the Reserve Bank,
the risk-based approach to supervision has been adopted since 2003 and about 23 banks have been
brought under the fold of risk-based supervision (RBS) on a pilot basis. On the basis of the feedback
received from the pilot project, the RBS framework is being reviewed.
As part of the reform programme, due consideration has been given to diversification of ownership of
banking institutions for greater market accountability and improved efficiency. The public sector banks
expanded their capital base by accessing the capital market, which diluted the Government ownership.
To provide banks with additional options for raising capital funds with a view to enabling smooth
transition to the Basel II, the Reserve Bank in January 2006, allowed banks to augment their capital
funds by issue of additional instruments.
With a view to enhancing efficiency and productivity through competition, guidelines were laid down for
establishment of new banks in the private sector and the foreign banks have been allowed more
liberal entry. Since 1993, 12 new private sector banks have been set up. As a major step towards
enhancing competition in the banking sector, foreign direct investment in the private sector banks is
now allowed up to 74 per cent, subject to conformity with the guidelines issued from time to time. The
regulatory framework in India, in addition to prescribing prudential guidelines and encouraging market
discipline, is increasingly focusing on ensuring good governance through 'fit and proper' owners,
directors and senior managers of the banks. Transfer of shareholding of five per cent and above
requires acknowledgement from the Reserve Bank and such significant shareholders are required to
meet rigorous 'fit and proper' requirements. Banks have also been asked to ensure that the nominated
and elected directors are screened by a nomination committee to satisfy 'fit and proper' criteria.
Directors are also required to sign a covenant indicating their roles and responsibilities. The Reserve
Bank has issued detailed guidelines on ownership and governance in private sector banks
emphasising diversified ownership.
The Reserve Bank released a roadmap for foreign banks articulating a liberalised policy consistent
with the WTO commitments in March 2005. The roadmap is divided into two phases. During the first
phase, between March 2005 and March 2009, foreign banks wishing to establish presence in India for
the first time could either choose to operate through branches or set up 100 per cent wholly owned
subsidiaries (WOS), following the one-mode presence criterion. For new and existing foreign banks, it
is proposed to go beyond the existing WTO commitment of 12 branches in a year. During this phase,
permission for acquisition of shareholding in Indian private sector banks by eligible foreign banks will
be limited to banks identified by the Reserve Bank for restructuring. The second phase is scheduled to
commence from April 2009 after a review of the experience gained and after due consultation with all
the stakeholders in the banking sector. In this phase, three interconnected issues would be taken up.
First, rules for the removal of limitations on the operations of the WOS and treating them at par with
domestic banks, to the extent appropriate, would be designed and implemented. Second, the WOS of
foreign banks, on completion of a minimum prescribed period of operation, may be allowed to list and
dilute their stake so that, consistent with the guidelines issued on March 5, 2004, at least 26 per cent
of the paid-up capital of the subsidiary is held by resident Indians at all times. Third, during this phase,
foreign banks may be permitted to enter into merger and acquisition transactions with any private
sector bank in India, subject to the overall investment limit of 74 per cent.
In recent years, comprehensive credit information, which provides details pertaining to credit facilities
already availed of by a borrower as well as his payment track record, has become critical. 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.
The Banking Ombudsman Scheme was notified by the Reserve Bank in 1995 to provide for a system
of redressal of grievances against banks. The scheme sought to establish a system of expeditious and
inexpensive resolution of customer complaints. The scheme was revised twice, first in 2002 and then
in 2006. At present, the scheme is being executed by Banking Ombudsman (BO) appointed by the
Reserve Bank at 15 centres covering the entire country. The BO scheme covers all commercial banks
and scheduled primary cooperative banks. The scheme was revised recently which brought more
grounds of complaints within its ambit.
An independent Banking Codes and Standards Board of India was set up on the model of the UK in
order to ensure that comprehensive code of conduct for fair treatment of customers is evolved and
adhered to. With a view to achieving greater financial inclusion, since November 2005, all banks need
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. Banks were
urged to review their existing practices to align them with the objective of 'financial inclusion'.
The smooth functioning of the payment and settlement system is a pre-requisite for financial stability.
The Reserve Bank, therefore, has taken several measures from time to time to develop the payment
and settlement system in the country along sound lines. The Board for Regulation and Supervision of
Payment and Settlement Systems (BPSS), set up in March 2005 as a committee of the Central Board
of the Reserve Bank, is the apex body for giving policy direction in the area of payment and settlement
systems. Real time gross settlement (RTGS) was operationalised on March 26, 2004. Its usage for
transfer of funds, especially for large values and for systemically important purposes, has increased
since then. With introduction of RTGS, whereby a final settlement of individual inter-bank fund
transfers is effected on a gross real time basis during the processing day, a major source of systemic
risk in the financial system has been reduced substantially.
A risk free payments and settlements system in government securities and foreign exchange was
established by the Clearing Corporation of India Limited (CCIL), which is set up by banks. CCIL acts
as the central counter party (CCP) for all the transactions and guarantees both the securities and
funds legs of the transaction. Under the DvPIII mode of settlement that has been adopted, both the
securities leg and the fund leg are settled on a net basis. The settlement through CCIL has thus
reduced the gross dollar requirement by more than 90 per cent. A screen-based negotiated
quotedriven system for dealings in the call/notice and the term money market (NDS-CALL) has been
launched by the CCIL in September 18, 2006. The introduction of NDS-CALL helps in enhancing
transparency, improving price discovery and strengthening market microstructure.
Impact of financial sector reforms in India
albeit
Banks have been accorded greater discretion in sourcing and utilisation of resources, in an
increasingly competitive environment. The outreach of the Indian banking system has increased in
terms of expansion of branches/ATMs. In the post-reform period, assets/liabilities of banks have grown
consistently at a high rate. The financial performance of banks also improved as reflected in their
increased profitability. Net profit to assets ratio improved from 0.49 per cent in 2000-01 to 1.13 per
cent in 2003-04. Although it subsequently declined to 0.88 per cent in 2005-06, it was still significantly
higher than that in the early 1990s. Banks have been successful in weathering the impact of upturn in
interest rate cycle through increasing diversification of their income. Though banks had to incur huge
expenditures on upgradation of information technology, the restructuring of the workforce in public
sector banks helped them cut down the staff cost and increase in business per employee.
Another welcome development has been the sharp reduction in non-performing loans (NPLs). Both
gross and net NPLs started to decline in absolute terms since 2002-03. Gross NPLs as percentage of
gross advances, which were above 15 per cent in the early 1990s, are now less than 3 per cent. This
distinct improvement in asset quality may be attributed to the improved recovery climate underpinned
by strong macroeconomic performance as well as several institutional measures initiated by the
Reserve Bank/Government such as debt recovery tribunals, Lok Adalats, scheme of corporate debt
restructuring in 2001, the SARFAESI Act in 2002.
Since 1995-96, the banking sector, on the whole, has been consistently maintaining CRAR well above
the minimum stipulated norm. The overall CRAR for scheduled commercial banks increased from 8.7
per cent at end-March 1996 to 12.3 per cent at end-March 2006. The number of banks not complying
with the minimum CRAR also declined from 13 at end-March 1996 to just two by end-March 2006.
Improved capital position stemmed largely from the improvement in profitability and raising of capital
from the market, though in the initial stages the Government had to provide funds to recapitalise weak
public sector banks.
Even though public sector banks continue to dominate the Indian banking system, accounting for
nearly three-fourths of total assets and income, the increasing competition in the banking system has
led to a falling share of public sector banks, and increasing share of the new private sector banks,
which were set up around mid-1990s. It is clear that we are at the beginning of this new phase in the
Indian banking with competitive pressure, both domestic and external, catching up and the need for
banks to continuously reassess and reposition themselves in their business plans.
Future challenges for Indian banks
A few broad challenges facing the Indian banks are: threats of risks from globalisation; implementation
of Basel II; improvement of risk management systems; implementation of new accounting standards;
enhancement of transparency and disclosures; enhancement of customer service; and application of
technology.
Globalisation - a challenge as well as an opportunity
The waves of globalisation are sweeping across the world, and have thrown up several opportunities
accompanied by concomitant risks. Integration of domestic market with international financial markets
has been facilitated by tremendous advancement in information and communications technology.
There is a growing realisation that the ability of countries to conduct business across national borders
inter
and the ability to cope with the possible downside risks would depend, alia, on the soundness of
the financial system. This has necessitated convergence of prudential norms with international best
practices as well consistent refinement of the technological and institutional framework in the financial
sector through a non-disruptive and consultative process.
Opening up of the capital account
The Committee on Fuller Capital Account Convertibility (Chairman: Shri S.S. Tarapore) observed that
under a full capital account convertibility regime, the banking system would be exposed to greater
market volatility, and this necessitated enhancing the risk management capabilities in the banking
system in view of liquidity risk, interest rate risk, currency risk, counter-party risk and country risk that
arise from international capital flows. The potential dangers associated with the proliferation of
derivative instruments - credit derivatives and interest rate derivatives also need to be recognised in
the regulatory and supervisory system. The issues relating to cross-border supervision of financial
intermediaries in the context of greater capital flows are just emerging and need to be addressed.
Basel II implementation
The Reserve Bank and the commercial banks have been preparing to implement Basel II, and it has
been decided to allow banks some more time in adhering to new norms. As against the deadline of
March 31, 2007 for compliance with Basel II, it was decided in October 2006 that foreign banks
operating in India and Indian banks having presence outside India would 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, while all other scheduled commercial banks are required to migrate to Basel II
by March 31, 2009.
It is widely acknowledged that implementation of Basel II poses significant challenge to both banks
and the regulators. Basel II implementation may also be seen as a compliance challenge. But at the
same time, it offers two major opportunities to banks, viz., refinement of risk management systems;
and improvement in capital efficiency. The transition from Basel I to Basel II essentially involves a
move from capital adequacy to capital efficiency. This transition in how capital is used and how much
capital is needed will become a significant factor in return-on-equity strategy for years to come.
The reliance on the market to assess the riskiness of banks would lead to increased focus on
transparency and market disclosure, critical information describing the risk profile, capital structure and
capital adequacy. 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.
Improving risk management systems
Basel II has brought into focus the need for a more comprehensive risk management framework to
deal with various risks, including credit and market risk and their inter-linkages. Banks in India are also
moving from the individual silo system to an enterprise-wide risk management system. While the first
milestone would be risk integration across the entity, the next step would entail risk aggregation across
the group both in the specific risk areas as also across the risks. Banks would, therefore, be required
to allocate significant resources towards this endeavour. In India, the risk-based approach to
supervision is also serving as a catalyst to banks' migration to the integrated risk management
systems. However, taking into account the diversity in the Indian banking system, stabilizing the RBS
as an effective supervisory mechanism is another challenge.
Corporate governance
To a large extent, many risk management failures reflect a breakdown in corporate governance which
arise due to poor management of conflict of interest, inadequate understanding of key banking risks,
and poor Board oversight of the mechanisms for risk management and internal audit. Corporate
governance is, therefore, the foundation for effective risk managements in banks and, thus, the
foundation for a sound financial system. Therefore, the choices which banks make when they
establish their risk management and corporate governance systems have important ramifications for
financial stability. Banks may have to cultivate a good governance culture building in appropriate
checks and balances in their operations. There are four important forms of oversight that should be
included in the organisational structure of any bank in order to ensure appropriate checks and
balances: (i) oversight by the board of directors or supervisory board; (ii) oversight by individuals not
involved in the day-to-day running of the various business areas; (iii) direct line supervision of different
business areas; and (iv) independent risk management, compliance and audit functions. In addition, it
is important that key personnel are fit and proper for their jobs. Furthermore, the general principles of
sound corporate governance should also be applied to all banks, irrespective of their unique
ownership structures.
Implementation of new accounting standards
Derivative activity in banks has been increasing at a brisk pace. While the risk management
framework for derivative trading, which is a relatively new area for Indian banks (particularly in the
more structured products) is an essential pre-requisite, the absence of clear accounting guidelines in
this area is a matter of significant concern. The World Bank's ROSC on Accounting and Auditing in
India has commented on the absence of an accounting standard which deals with recognition,
measurement and disclosures pertaining to financial instruments. The Accounting Standards Board of
the Institute of Chartered Accountants of India (ICAI) is considering issue of Accounting Standards in
respect of financial instruments. These will be the Indian parallel to International Accounting Standards
32 and 39. The proposed Accounting Standards will be of considerable significance for financial
entities and could, therefore, have implications for the financial sector. The formal introduction of these
Accounting Standards by the ICAI is likely to take some time in view of the processes involved. In the
meanwhile, the Reserve Bank is considering the need for banks and financial entities adopting the
broad underlying principles of IAS 39. Since this is likely to give rise to some regulatory/prudential
issues, all relevant aspects are being comprehensively examined. The proposals in this regard would,
as is normal, be discussed with the market participants before introduction. Adoption and
implementation of these principles are likely to pose a great challenge to both the banks and the
Reserve Bank.
Supervision of financial conglomerates
The financial landscape is increasingly witnessing entry of some of the bigger banks into other
financial segments like merchant banking, insurance etc. Emergence of several new players with
diversified presence across major segments make it imperative for supervision to be spread across
various segments of the financial sector. In this direction, an inter-regulatory Working Group was
constituted with members from RBI, SEBI and IRDA. The framework proposed by the Group is
complementary to the existing regulatory structure wherein the individual entities are regulated by the
respective regulators and the identified financial conglomerates are subjected to focussed regulatory
oversight through a mechanism of inter-regulatory exchange of information. As a first step in this
direction, an inter-agency Working Group on Financial Conglomerates (FC) comprising the above
three supervisory bodies identified 23 FCs and a pilot process for obtaining information from these
conglomerates has been initiated. The complexities involved in the supervision of financial
conglomerates are a challenge not only to the Reserve Bank of India but also to the other regulatory
agencies, which need to have a close and continued coordination on an on-going basis.
In view of increased focus on empowering supervisors to undertake consolidated supervision of bank
groups and since the Core Principles for Effective Banking Supervision issued by the Basel Committee
on Banking Supervision have underscored consolidated supervision as an independent principle, the
Reserve Bank had introduced, as an initial step, consolidated accounting and other quantitative
methods to facilitate consolidated supervision. The components of consolidated supervision include,
consolidated financial statements intended for public disclosure, consolidated prudential reports
intended for supervisory assessment of risks and application of certain prudential regulations on group
basis. In due course, consolidated supervision as introduced above would evolve to cover banks in
mixed conglomerates, where the parent may be non-financial entities or parents may be financial
entities coming under the jurisdiction of other regulators.
Application of advanced technology
The role of technology in banking in creating new business models and processes, in maintaining
competitive advantage, in enhancing quality of risk management systems in banks, and in
revolutionising distribution channels, cannot be overemphasised. Recognising the benefits of
modernising their technology infrastructure, banks are taking the right initiatives. While doing so,
banks have four options to choose from: they can build a new system themselves, or buy best of the
modules, or buy a comprehensive solution, or outsource. A further challenge which banks face in this
regard is to ensure that they derive maximum advantage from their investments in technology and
avoid wasteful expenditure which might arise on account of uncoordinated and piecemeal adoption of
technology; adoption of inappropriate/ inconsistent technology and adoption of obsolete technology. A
case in point is the implementation of core banking solution by some banks without assessing its
scalability or adaptability to meet Basel II requirements.
Financial inclusion
While banks are focusing on the methodologies of meeting the increasing demands placed on them,
there are legitimate concerns with regard to the banking practices that tend to exclude rather than
attract vast sections of population, in particular pensioners, self-employed and those employed in
unorganised sector. While commercial considerations are no doubt important, banks have been
bestowed with several privileges, especially of seeking public deposits on a highly leveraged basis,
and consequently they should be obliged to provide banking services to all segments of the
population, on equitable basis. Further, experience has shown that consumers' interests are at times
not accorded full protection and their grievances are not properly attended to. Feedback received
reveals recent trends of levying unreasonably high service/user charges and enhancement of user
charges without proper and prior intimation. It is in this context that the Governor, Reserve Bank of
India had mentioned in the Annual Policy Statement 2005-06 that RBI will take initiatives to encourage
greater degree of financial inclusion in the country; setting up of a mechanism for ensuring fair
treatment of consumers; and effective redressal of customer grievances.
Conclusion
With the increasing levels of globalisation of the Indian banking industry, evolution of universal banks
and bundling of financial services, competition in the banking industry will intensify further. The
banking industry has the potential and the ability to rise to the occasion as demonstrated by the rapid
pace of automation which has already had a profound impact on raising the standard of banking
services. The financial strength of individual banks, which are major participants in the financial
system, is the first line of defence against financial risks. Strong capital positions and balance sheets
place banks in a better position to deal with and absorb the economic shocks.