Bimil Jalan: Strengthening Indian banking and finance - progress and
prospects
Speech by Dr Bimal Jalan, Governor of the Reserve Bank of India, at the Bank Economists'
Conference, Bangalore, 27 December 2002.
I am thankful to Dr Michael Debabrata Patra of the Reserve Bank of India for his help in the preparation of this
address.
* * *
The Bank Economists' Conference has become an important annual event for constructive
interactions and informed debate on the state of our financial system. The theme chosen for this year,
"Indian Banking: Managing Transformation", provides an excellent opportunity to reflect on the ground
that has been covered in transforming Indian banking into a vibrant, sound and a well-functioning
system, and to chart out a plan for the future. I am happy to be here with you again to deliver the
inaugural address to the 24th Conference of Bank Economists.
As I have emphasised during our earlier interactions, there are several elements that must come
together in order to make the Indian banking system stronger, efficient and low-cost. These
'fundamentals' include:
- strengthening of prudential norms and market discipline;
- adoption of international benchmarks as appropriate to our situation;
- management of organisational change and consolidation within the financial system;
- upgradation of the technological infrastructure of the financial system, and
- human resource development as the catalyst of the transformation.
We have made some progress in each of these areas; yet some concerns persist regarding the pace
and quality of our progress. Macroeconomic and financial conditions around us are also changing
swiftly, posing new challenges and lending urgency to accelerating our efforts towards our vision. In
my address today, I propose to take stock of the ground covered in each of the areas that I have
outlined. I hope this will help to shed some light on the road ahead.
II. Recent macroeconomic and financial developments
The global financial markets have weakened significantly since end-March 2002, reflecting a
downward revision in profit forecasts and concerns about the sustainability of the recovery. Corporate
sector distress and auditing and accounting irregularities in June and early July 2002 severely
undermined investor confidence and deepened the slump in equity markets. Negative sentiment
spilled over into the corporate bond market, reflected in a sharp rise in interest rate spreads; and
portfolio changes indicate a continuing flight to quality and safety. International banking activity
experienced a slowdown, affected by subdued demand for credit and consolidation of off-shore
lending. Adjustments are underway between the major currencies, driven by the decline in equity
markets and the realignment of the US dollar. Emerging markets have also witnessed turbulence,
largely due to country-specific factors, including concerns about debt dynamics and political
uncertainties.
The current phase of the banking cycle appears to be driven by the downturn in economic activity
rather than financial distress. Significantly, the largest financial institutions are among those affected
by credit concerns. The slowdown in the demand for financing has been aggravated by a deterioration
in the quality of portfolios on the assets side and the consequent tightening of lending norms. All this
has rendered the short-term outlook uncertain. The silver lining in the otherwise sombre global
macroeconomic and financial situation has been Asia. Emerging Asia has been experiencing a
stronger than expected recovery. Although equity markets have exhibited a decline, most countries of
the region have retained access to international capital markets and international bank lending.
The Indian economy has recently been exhibiting signs of staying ahead of global activity. Some signs
of cyclical recovery are currently evident, although border tensions, a relatively weak and uneven
monsoon and concerns relating to the fiscal position are downside risks restraining a fuller surge of
growth. Real GDP in agriculture could decline by about 1.5 per cent for the year as a whole, reflecting
mainly the anticipated shortfall in foodgrains production. Industrial performance in the first half of the
year appears to have shrugged off the sluggishness experienced in the preceding year. All constituent
sectors of industry have recorded improvement in growth, led by manufacturing. Significantly, the
production of the infrastructure industries and capital goods growth has also revived. Export growth
has turned out to be robust in the first half of the year. Non-oil imports have risen over last year's level
suggesting that the slackening of domestic demand seems to be flattening out. Given these lead
indicators, real GDP growth of 5.0 to 5.5 per cent during 2002-03 appears feasible. Inflation, measured
as year-on-year variations in the wholesale price index (WPI), has been hovering around 3.0 per cent
in recent weeks. The range of inflation indicators has shifted down to 2.3-3.9 per cent from 3.0-6.3 per
cent a year ago. Nevertheless, the inflation outlook is uncertain with international oil prices volatile with
perceptions of war risk, and with domestic oilseeds and edible oil prices rising. For the year as a
whole, inflation is expected to remain within 4.0 per cent in the current year.
The financial system is also providing clear indications of a pick up in activity. There has been
improvement in the growth of non-food bank credit reflecting a better outlook for industrial growth.
There has been an increase in the credit disbursed to the housing sector and industries like coal, iron
and steel, textiles, fertiliser, drugs and pharmaceuticals, cement, construction, petroleum, computer
software, automobiles, gems and jewellery and power. The increase in credit demand is not, however,
evenly spread. The investment of scheduled commercial banks in non-SLR instruments has shown a
distinct improvement from a comparatively negligible level last year. Money supply has been
(M3)
tracking real output developments and inflation conditions with a continuing preference for safety
reflected in the appetite for bank deposits.
Although various segments of the Indian financial markets have remained relatively unaffected by
international financial developments, equity markets have moved down along with global equity
markets. On the other hand, the strength of capital flows has resulted in a modest appreciation of the
exchange rate of the rupee vis-a-vis the US dollar. First quarter balance of payments data indicate that
the current account remains in surplus as in the preceding year. The foreign exchange reserves have
risen to a level of US $ 67 billion, currently the seventh largest in the world. Under these conditions,
the stance of monetary policy, reiterated recently in the Statement on the mid-term review of monetary
and credit policy on October 29, 2002, is provision of adequate liquidity to meet credit growth and
support investment demand, consistent with price stability; to continue the soft interest rate stance and
greater flexibility in the interest rate structure over the medium term. The policy stance was signalled
through 25 basis points cuts each in the Bank Rate and the repo rate. Monetary policy also renewed
its commitment to monitoring conditions in the foreign exchange market with watchfulness as well as
flexibility.
Financial intermediation is not just a mirror of the real economy; it is also a derivative. Around us, the
prolonged global slowdown is increasingly reflected in heightened risk aversion in international
financial markets. Fortunately for us in India, we seem to be breaking out early from the synchronised
global downturn. Our banks, financial institutions and financial markets have responded encouragingly
to the impulses for growth, reinforcing the virtuous aspects of the movement between real and
financial activity. It is vital that we take advantage of this early lead and seize the opportunities for
financial intermediation in the recovery phase of the business cycle.
III. Strengthening the financial system
Strengthening of the financial sector and improving the functioning of financial markets can be
described as the core principles of financial sector reforms in India. The central plank is a set of
prudential norms that are aimed at imparting strength to banks and financial institutions, and inducing
greater accountability and market discipline. These norms include not only capital adequacy, asset
classification and provisioning but also accounting standards, exposure and disclosure norms and
guidelines for investment, risk management and asset-liability management. Our approach has been
to benchmark our norms against international standards.
By the end of March 2002, 25 out of 27 public sector banks had risk weighted capital adequacy ratios
above the prescribed minimum of 9 per cent with 23 in excess of 10 per cent. Strategies are being
worked out to turn around the two weak public sector banks including recapitalisation. Capital
adequacy has improved significantly in other segments too i.e., financial institutions in the regulatory
domain of the Reserve Bank (except for IFCI), non-bank financial companies (NBFCs) and other
segments of the banking industry except for cooperative banks. Banks have been making equity
offerings and issuances of subordinated debt for inclusion under tier-II capital under transparent and
non-discretionary guidelines. A cumulative amount of capital of Rs.867 crore has been returned by
public sector banks to the Government.
Capital adequacy in banks and financial institutions has become a matter of considerable international
attention, particularly after the Asian crisis. The draft of a new Capital Accord, proposed for
implementation in 2006, envisages increased risk sensitivity of capital ratios, refinement of measures
of credit risk including a greater role for external credit rating, flexibility and national discretion rather
than a one-size-fits-all approach. The Reserve Bank's position has been that the new Accord should
focus primarily on complex and internationally active banks while national choices of methodologies
for assigning risk weights on capital ratios be accommodated within its framework. India is also
engaging in collaborative studies to assess the potential impact of the new Accord.
Banks are being prepared for tightening of the norms for asset classification with convergence to
international standards by March 2005. The 90-day norm for recognition of loan impairment will come
into operation from 2004-05 and this is now applicable for all segments of the financial system.
Phased provisioning and charging of interest on monthly rests are seen as immediate steps in the
preparation.
Exposure norms in respect of single/group borrowers have been set up to limit the credit risk in banks'
portfolios and are linked to capital. Additional disclosures have been prescribed in notes to accounts of
balance sheets. Asset liability management systems are being constantly refined with tolerance levels
prescribed on all time bands for liquidity/interest rate sensitivity mismatches. There has been
considerable progress in the implementation of risk management systems although there is a need for
substantial upgradation of management information systems, preparation of contingency plans and
stress testing. Internal systems need to be developed further for quantifying and monitoring
operational risk.
A major drag on financial sector reforms in India is the slow progress in the management of
nonperforming assets (NPA). Although net NPAs have undergone a steady decline since 1992-93, they
are still high by the international standard of about 2 per cent. The cumulative provisions against loan
losses at 43 per cent of gross NPAs is also extremely low by international standards. From the
regulator's perspective, NPA management involves four steps i.e., assessment, provisioning, recovery
and prevention. A menu approach is adopted in India which involves intensification of recovery with
ongoing tightening of norms for assessment and provisioning.
Settlement advisory committees were introduced in 1999 to provide a simplified non-discretionary and
non-discriminatory mechanism to deal with the stock or 'overhang' of NPAs especially in the small
sector. The effectiveness of debt recovery tribunals was enhanced through the amendment of relevant
legislation in 2000. In the recent period, there has been a substantial increase in the number of cases
disposed of by these tribunals. In 2001, a corporate debt restructuring mechanism as prevalent in the
UK and South East Asian countries was finalised for restructuring debts of viable corporate entities.
Lok Adalats have proved to be an effective institution for settlement of similar dues. The Union Budget
for 2002-03 announced the setting up of a pilot Asset Reconstruction Company with the participation
of banks, financial institutions and multilateral agencies. The new Credit Information Bureau will
provide an institutional mechanism for sharing of information on borrowers.
A recent landmark development which should have a long term favourable impact in reducing the level
of NPAs is the passage of the Securitisation and Reconstruction of Financial Assets and Enforcement
of Security Interest Act. It lays out the conditions to be satisfied for the establishment of securitisation
or reconstruction companies, the terms for acquisition of financial assets by these companies,
enforcement of security interest, dispute settlement procedures, prudential norms, offences and
penalties. The Act empowers banks and financial institutions with appropriate legal authority to speed
up the recovery of the stock of impaired assets through a one-time cleaning of balance sheets. This is
expected to improve their financial health and functioning considerably.
Efforts have been simultaneously undertaken to broaden and deepen the various segments of the
financial market spectrum. The call money market is emerging as a pure inter-bank market and activity
is rising in the repo market for non-banks. The development of money market segments has gone
hand in hand with rationalisation of standing liquidity facilities at the Reserve Bank. In the gilt market,
there is greater transparency, new instruments have been introduced, and there is a progressive
widening of the investor base. With the operationalisation of the Negotiated Dealing System, price and
trade information is available on a near real time basis. The Clearing Corporation of India has also
launched net foreign exchange clearing in India on a guaranteed settlement basis. These
developments bring us closer to our goal of transforming our financial system into a resilient and
competitive structure with market participants operating in different segments of the financial markets
catering to varying classes of financial assets and liabilities.
IV. Transparency and market discipline
There is now a wider appreciation that high quality financial reporting - described as the 'cornerstone
of market discipline' - is essential for the efficiency and stability of the financial system. Structural
changes underway in the financial system have only served to raise the premium on market
disclosure. Globalisation has brought with it stringent quality criteria as the emphasis is increasingly on
comparability of information. Pillar III in the revised Basel Capital Accord is the most recent example.
Financial innovations have made the interpretation of disclosures more difficult, testing severely
existing measurement techniques. At the same time, availability of information is vital since it is the
basis on which perceptions and expectations are formed, which ultimately drive markets and even
business cycles.
Information conveyed by the balance sheet, income and cash flow statements is the bread and butter
of traditional accounting. Risk information is supplied primarily through supplementary risk disclosures.
Both are important for an efficient allocation of resources and financial discipline. We have been
intensifying ongoing efforts to make the balance sheet and profit and loss accounts of banks more
reflective of their true financial health. From March, 2003 banks would be required to conform to
Accounting Standards issued by the Institute of Chartered Accountants of India. Banks are also
required to make additional disclosures in notes to accounts on risk features such as movement in
provisions held towards non-performing assets and depreciation of investments, capital market
exposures and loans subject to corporate debt restructuring. These requirements are applicable to
financial institutions as well. In the April, 2002 Monetary and Credit Policy Statement banks have been
required to announce the maximum spread over their prime lending rates (PLR) along with their PLR
announcements, the minimum and maximum rates charged to borrowers, deposit rates, the effective
annualised return to the depositor and processing and service charges. These disclosures serve the
interests of customers, besides fostering healthy competition among banks. The Reserve Bank, too, is
expanding its disclosure to the markets, even while setting for itself exacting standards of quality and
timeliness. A recent example is the release of daily cumulative balances held by banks with the
Reserve Bank, over and above its daily, weekly, monthly and less frequent disclosure of information
and analysis of a wide array of macroeconomic and financial variables.
In India, credit-related information in the banking sector is confidential in nature and lenders are bound
by the secrecy embodied in the present legal framework. The Credit Information Bureau is intended to
economise on the production costs associated with the supply of financial information for a potential
clientele comprising 101 banks, 22 non-banking finance companies and 30 housing finance
companies in India, as well as a large number of co-operative banks and other regional credit
grantors. The Bureau expects to provide more effectively organised information and to circumvent the
constraint of limited infrastructure of some of the participants in the financial system. The Bureau is
expected to launch commercial operations in the first quarter of 2003.
The content of information is important and perhaps the most difficult to address in the context of
financial sector reforms. The key challenge is to close the gap between economic and accounting
valuations. The prevailing mixture of historical cost and mark-to-market accounting is unsatisfactory.
For traded assets and liabilities, marking to market is suitable. For non-traded instruments, imputing
valuations in a verifiable manner is a major challenge. Since September 30, 2000 in line with
international best practice, banks are required to classify their investment portfolios into 'held to
maturity', 'available for sale' and 'held for trading' categories, the first being in the nature of permanent
investments at historical valuation, not exceeding 25 per cent of total investments, but the latter two
categories being marked-to-market at yearly and monthly intervals (or even more frequently),
respectively.
Banks are being encouraged to set up Investment Fluctuation Reserve (IFR) accounts as part of
prudent policies for utilising the gains from sale of investments in securities in the current benign
interest rate regime so that they are adequately protected against any reversal of the interest rate
environment. Realised gains from sale of securities can be transferred to these IFRs, which vary
between 5 and 10 per cent of bank portfolios and qualify for inclusion in tier II capital. Unrealised gains
should not be taken to the income account or to the IFR.
As regards the reliability of disclosure, the choice is narrowing down world wide to rule-based versus
principle-based standards. Undoubtedly, principles need to be given added content before they can be
applied effectively and enforced. The growing complexity of financial innovations is defeating the
sustainable application of detailed rules: they can be circumvented through creative accounting. It is
for this reason that a decisive preference is emerging for principle-based disclosure. There is also a
distinct shift in the approach of the Reserve Bank, for instance, with circulars and instructions being
replaced rapidly by guidelines, guidance notes, illustrations of conformity nuances and extensive
consultations with banks on recommendations of relevant working groups before they are
implemented. Indeed, similar considerations are pushing prudential authorities away from quantitative
rules towards qualitative supervisory oversight in recent years.
V. Structural changes in the banking system
Financial systems worldwide are undergoing structural transformation. Technological innovation,
deregulation of financial services at the national level, external financial liberalisation, and
organisational changes in the corporate world are some of the global factors driving the
transformation. Banking and finance in emerging economies is also caught up in this change. In these
economies, in addition to global developments, country-specific factors are motivating the structural
shifts. Consequently, two separate directions of reform are evident. There is an expansion of the
financial system due to vacation of policy interventions in entry, exit and operations, the application of
new advances in information technology and in general, a greater emphasis on competition and
market-based outcomes. Almost contemporaneously, there is a strong drive towards consolidation in a
quest for exploiting core competitiveness and for developing "niche" strategies.
In India, the primary force for transformation was structural reforms launched in the aftermath of the
balance of payments crisis of 1990-91. It was recognised that a vibrant, resilient and competitive
financial sector is vital for sustaining the reform process in the real sectors of the economy.
Significantly, financial sector reforms in India were pre-emptive and proactive rather than a result of
banking crises, as has been the experience of several emerging economies. Secondly, the momentum
of change in the financial system has been the motivation for upgrading the technological
infrastructure in Indian banking and finance rather than the other way round. In that sense, the Indian
financial system has been a late entrant in the expressway created by the information and
communication technology revolution. Thirdly, competitive pressure - a major force of change
worldwide - has been reforms-driven rather than a driver of the transformation. Finally, a large
measure of the impetus for change has come from reforms in the regulatory and supervisory regime
and the aspiration to apply international best practices to the country-specific situation.
The role of the public sector banks has come under close scrutiny in the recent period. It is necessary
to recognise that these banks have played a critical role in the development of the Indian economy in
the period 1969-90, particularly in the spread of banking and monetisation of the economy, the
mobilisation of savings and their allocation by plan priorities. For all economies in the early and
intermediate stages of development, credit markets face a persistent excess demand, reflecting the
existing resource constraints. Moreover, market processes can well exclude the genuine credit needs
of the weaker sections of society which do not have the competitive strength to bid for funds in the
market for bank credit. Public ownership in Indian banking was intended to address both concerns i.e.,
the rationing of credit in the face of excess demand not cleared by the market, and the channelling of
bank credit flow to the economically disadvantaged sections of society. Over the period 1970-90, a
massive expansion of bank branches occurred, and credit allocations ensured some equity in the
distribution of bank credit.
At the same time, however, there was erosion in the financial health of public sector banks and
deterioration in the quality of customer service. Within the ambit of financial sector reforms therefore,
the focus since the early 1990s has been on the viability, efficiency and competitiveness of banks and
financial institutions. Liberalisation and deregulation has to go hand in hand with a greater emphasis
on consolidation, productivity, asset quality and profitability. There is also an urgent need for
Government to divest substantial shareholding to the public, so that these banks can respond
effectively to changing market conditions. Under the present circumstances, improvement in the cost
structure of the banks and work culture are important priorities.
In order to enable the public sector banks to deal with the new capital requirements as per
international guidelines, recapitalisation was initiated in 1993, aggregating Rs. 20,446 crore by the end
of the 1990s. The Verma Committee's recommendation that recapitalisation of 'weak' public sector
banks be accompanied by conditionality relating to managerial and operational aspects of the banks'
functioning was endorsed in the Union Budget, 2000-01. Accordingly, in 2001-02, a sum of Rs.1,300
crore was provided to one of the weak nationalised banks. Two of the weak banks have already
turned around and are reporting profits and a capital adequacy ratio of 9 per cent. The last one is also
going through a turnaround. Recapitalisation is associated with a monitorable reform programme and
operational restructuring to ensure that flow problems in a bank's performance are dealt with.
Mergers have reflected efforts to reap economies of scale and scope through joint production of
financial services and one-stop delivery wherever synergies in service supply can be exploited to
lower costs of production. In general, these mergers have come about as a result of government
efforts to restructure inefficient national financial systems. Market-driven consolidation is a relatively
new phenomenon in these countries. A critical issue in almost all emerging economies is a
reassessment of the ownership of the State in the financial system and a redefinition of the role of
State-owned banks and financial institutions. The changing structure of the banking and financial
systems in emerging economies has implications for systemic stability and the supervisory regime.
A major structural change in our financial system is the infusion of competition. The enabling
conditions for a more competitive environment initially took the form of shifts in the policy regime.
Statutory pre-emptions were progressively lowered, interest rates were deregulated and restrictions on
entry and exit were eased. Financial markets were developed to enable financial intermediaries to deal
in assets and liabilities of varying maturities and risk profiles. Activity restrictions were eased and
banks can now undertake various types of activities reserved earlier for development financial
institutions. Likewise, the term-lending financial institutions have been allowed to undertake working
capital financing. Elements of this growing convergence have determined the pace and sequencing of
the approach to universal banking in the recent years.
Within the banking system, there is heightened competition with the introduction of new generation
private sector banks. In January 2001, revised guidelines were issued for entry of new banks in the
private sector. Despite the preponderant share of domestic banks in banking activity in India, foreign
banks have been a source of competition, at least potentially, given their use of sophisticated
technology, risk monitoring analysis and exposure management. In recent years, the policy thrust has
been to level the playing field for domestic and foreign banks. For example, foreign banks that were
earlier allowed to operate only branches but not subsidiaries, are now free to choose to set up either
branches or subsidiaries under common banking regulations including lending norms. Appropriate
legislative changes are also under consideration of the Government. Foreign direct investment up to
49 per cent has been allowed in private sector banks and up to 20 per cent in nationalised banks.
Guidelines have been issued for the entry of banks into insurance business either as joint venture
participants or to take up strategic investment for providing infrastructure and services support without
any contingent liability.
VI. Issues in supervision and regulation
Recent international financial developments have underscored the critical role of the regulatory and
supervisory function in ensuring the health and stability of the financial system. There is now a
worldwide debate on how to strengthen financial regulation even further, including proactively, to
contend with the dangers posed by creative accounting practices, even as the depressed state of
economic activity exerts conflicting pulls on the extent of supervisory rigour. At the same time, the
impact of technological advancement, financial liberalisation and the degree of integration between
domestic and international financial markets has rendered the conduct of oversight of the financial
system a highly complex task.
Regulatory and supervisory authorities need to be regarded as providing a range of services to the
community. This includes the establishment of specific rules of behaviour for participants in the
financial system, monitoring the observance of the rules, and general supervision of the behaviour of
financial entities. Unlike other services, however, these are not supplied through market processes but
laid down by the regulator after necessary consultations. The primary need for regulation arises from
the fact that consumers of financial services are not in a position to evaluate the soundness and safety
of financial entities since even the most stringent laws regarding enforceability of contracts cannot
protect for post-contract-signing behaviour. Therefore, the rationale for financial regulation lies in the
economic costs imposed on society by the external effects of financial market failure which can
threaten systemic stability. There is also a potential for gridlocks in the financial system due to adverse
selection and moral hazard problems. At the same time, substantial benefits can accrue from
correction of market imperfections, reduced transaction costs, and in general, providing people with a
financial system they can trust.
In India, progressive strengthening of the regulatory and supervisory framework has been a key
element of financial sector reforms since their inception. There has been progress in achieving
international best practices in banking supervision and this has been noted even in external audits
conducted by the IMF. Within the process of convergence with the best practices, fine-tuning is
undertaken keeping in view the country-specific circumstances. An example of this is the approach
being evolved towards consolidated supervision and the compliance of banks with accounting
standards.
In recent years, there has been a shift in emphasis from micro-regulation to macro-management,
supported by a tightening of prudential norms and improvements in the functioning of financial
markets. A clearer definition of the regulatory role of the Reserve Bank is also being considered within
the broader debate on the conflict of interest between ownership and regulation. The supervisory
strategy of the Board for Financial Supervision, which is entrusted with the supervision of banks,
allIndia financial institutions, non-bank financial companies and systemically important institutions,
consists of combining a restructured system of on-site inspection with off-site surveillance, enhancing
the role of external auditors and strengthening corporate governance, internal controls and audit
procedures. Under the OSMOS system, monthly returns provide information on exposure to sensitive
sectors, market risks and macro-prudential early warning indicators. Banks need to prepare for
switching to risk-based supervision by 2003 by identifying information gaps in the compilation of risk
profiles and training to personnel. The supervisory follow-up process will then involve a monitorable
action plan including remedial actions and timely corrective steps.
Banks are being encouraged to improve the reliability and robustness of their risk management,
management information and supervisory reporting systems. A scheme of prompt corrective action
based on early warning triggers is being d