Y V Reddy: Public sector banks and the governance challenge - the Indian
experience
Paper presented by Dr Y V Reddy, Deputy Governor of the Reserve Bank of India, at the World Bank,
International Monetary Fund, and Brookings Institution Conference on Financial Sector Governance:
The Roles of the Public and Private Sectors, New York, 18 April 2002.
The references for the speech can be found on the Reserve Bank of India's website.
* * *
The objective of this paper is to detail the Indian experience in meeting the governance challenge with
special reference to public sector banks (PSBs) or State-owned banks as they are described in some
countries. The paper sets out the historical context of the Indian experience since the governance
challenge is significantly related to the background in which state ownership emerged. This will be
followed by an account of the pre-reform status encompassing the policy, regulatory and structural
environments. The measures undertaken to tackle the governance issues during the reform follow. In
the context of the recent on-going exercise relating to India's status, vis-à-vis the international
standards and codes, an assessment would be made on the governance issues with special reference
to the banking sector, based essentially on the assessment of independent advisory groups and
current proposals under consideration for enhancing corporate governance in the public sector banks
are discussed. An attempt would be made to highlight what may be termed as tentative issues and
lessons emerging from the Indian experience. By way of a summing up, some random thoughts are
set out to provoke analysis and debate on the subject.
Historical context
India had a fairly well developed commercial banking system in existence at the time of independence
in 1947. The Reserve Bank of India (RBI) was established in 1935. While the RBI became a state
owned institution from January 1, 1949, the Banking Regulation Act was enacted in 1949 providing a
framework for regulation and supervision of commercial banking activity. The first step towards the
nationalisation of commercial banks was the result of a report (under the aegis of RBI) by the
Committee of Direction of All India Rural Credit Survey (1951) which till today is the locus classicus on
the subject. The Committee recommended one strong integrated state partnered commercial banking
institution to stimulate banking development in general and rural credit in particular. Thus, the Imperial
Bank was taken over by the Government and renamed as the State Bank of India (SBI) on July 1,
1955 with the RBI acquiring overriding substantial holding of shares. A number of erstwhile banks
owned by princely states were made subsidiaries of SBI in 1959. Thus, the beginning of the Plan era
also saw the emergence of public ownership of one of the most prominent of the commercial banks.
There was a feeling that though the Indian banking system had made considerable progress in the
'50s and '60s, it established close links between commercial and industry houses, resulting in
cornering of bank credit by these segments to the exclusion of agriculture and small industries.
To meet these concerns, in 1967, the Government introduced the concept of social control in the
banking industry. The scheme of social control was aimed at bringing some changes in the
management and distribution of credit by the commercial banks. The close link between big business
houses and big banks was intended to be snapped or at least made ineffective by the reconstitution of
the Board of Directors to the effect that 51 per cent of the directors were to have special knowledge or
practical experience. Appointment of whole-time Chairman with special knowledge and practical
experience of working of commercial banks or financial or economic or business administration was
intended to professionalise the top management. Imposition of restrictions on loans to be granted to
the directors' concerns was another step towards avoiding undesirable flow of credit to the units in
which the directors were interested. The scheme also provided for the take-over of banks under
certain circumstances.
Political compulsion then partially attributed to inadequacies of the social control, led to the
Government of India nationalising, in 1969, 14 major scheduled commercial banks which had deposits
above a cut-off size. The objective was to serve better the needs of development of the economy in
conformity with national priorities and objectives. In a somewhat repeat of the same experience,
eleven years after nationalisation, the Government announced the nationalisation of six more
scheduled commercial banks above the cut-off size. The second round of nationalisation gave an
impression that if a private sector bank grew to the cut-off size it would be under the threat of
nationalisation.
From the fifties a number of exclusively state-owned development financial institutions (DFIs) were
also set up both at the national and state level, with a lone exception of Industrial Credit and
Investment Corporation (ICICI) which had a minority private share holding. The mutual fund activity
was also a virtual monopoly of Government owned institution, viz., the Unit Trust of India. Refinance
institutions in agriculture and industry sectors were also developed, similar in nature to the DFIs.
Insurance, both Life and General, also became state monopolies.
Pre-reform status
The regulatory framework for the banking industry under the Banking Regulation Act was
circumscribed by the special provisions of the Bank Nationalisation Act both of which had elements of
corporate governance incorporated with regard to composition of Board of Directors in terms of
representation of directors, etc. While technically there was competition between banks and
nonbanks and among banks, substantively, competition was conditioned by policy as well as regulatory
environment, common ownership by the Government and agreement between the Government of
India as an owner and the workers represented by the Unions. Subsequent efforts during the reform
period in terms of hesitancy in permitting industrial houses as well as foreign owned banks should be
viewed in this historical context.
As regards the policy environment, it must be recognised that almost the whole of financial
intermediation was on account of public sector, with PSBs being the most important source of
mobilisation of financial savings. Resources for DFIs were also made available either by banks or
mostly created money and governmental support. The major thrust was on expansion of banks'
branches, provision of banking services and mobilisation of deposits. The interest rate regime was
administered with interest rates fixed both on deposits and lending. At the same time, there was large
pre-emption of banks' resources under the cash reserve ratio or in the form of statutory liquidity ratio.
The delivery of credit was also by and large directed through an allocative mechanism or as an adjunct
to the licensing regime. In the process, the private sector banks tended to be confined to the local
areas and were unable to expand in such an environment. Banks, mainly public sector banks became
the most dominant vehicle of the financial intermediation in the country. To a large extent, entry was
restricted and exit was impossible and there was little or no scope for functions of risk assessment and
pricing of risks. The Government, thus combined in itself the role of owner, regulator and sovereign.
The legal as well as policy framework emphasised co-ordination in the interest of national
development as per Plan priorities with the result, the issue of corporate governance became
subsumed in the overall development framework. To the extent each bank, even after nationalization,
maintained its distinct identity, governance structure as incorporated in the concerned legislations
provided for a formal structure of relationship between the RBI, Government, Board of Directors and
management. The role of the RBI as a regulator became essentially one of being an extended arm of
the Government so far as highest priority was accorded to ensuring coordinated actions in regard to
activities particularly of PSBs. The SBI, which was owned by the RBI, was in substance no different
from the other banks owned by the Government in terms of Board composition, appointment
procedures of the executives and non-executive members of the Board of Directors. Both Government
and RBI were represented on the Board of Directors of the PSBs. There has been significant cross
representation in terms of owner or lender and in other relationships between banks and all other
major financial entities. In other words, cross holdings and inter-relationships were more a rule than an
exception in the financial sector, since the basic objective was coordination for ensuring planned
development, with the result, the concepts of conflicts of interests among players, checks and
balances etc., were subordinated to the social goals of the joint family headed by the Government.
Reform measures
The major challenge of the reform has been to introduce elements of market incentive as a dominant
factor gradually replacing the administratively coordinated planned actions for development. Such a
paradign shift has several dimensions, the corporate governance being one of the important elements.
The evolution of corporate governance in banks, particularly, in PSBs, thus reflects changes in
monetary policy, regulatory environment, and structural transformations and to some extent, on the
character of the self-regulatory organizations functioning in the financial sector.
Policy environment
During the reform period, the policy environment enhanced competition and provided greater
opportunity for exercise of what may be called genuine corporate element in each bank to replace the
elements of coordinated actions of all entities as a "joint family" to fulfill predetermined Plan priorities.
The measures taken so far can be summarized as follows:
First, greater competition has been infused in the banking system by permitting entry of private sector
banks (9 licences since 1993), and liberal licensing of more branches by foreign banks and the entry
of new foreign banks. With the development of a multi-institutional structure in the financial sector,
emphasis is on efficiency through competition irrespective of ownership. Since non-bank
intermediation has increased, banks have had to improve efficiency to ensure survival.
Second, the reforms accorded greater flexibility to the banking system to manage both the pricing and
quantity of resources. There has been a reduction in statutory preemptions to less than a third of
commercial banks resources. The mandatory component of market financing of Government
borrowing has decreased. While directed credit continues it is now on near commercial terms.
Valuation of banks' investments is also attuned to international best practices so as to appropriately
capture market risks.
Third, the RBI has moved away from micro-regulation to macro-management. RBI has replaced
detailed individual guidelines with general guidelines and now leaves it to individual banks' boards to
set their guidelines on credit decisions. A Regulation Review Authority was established in RBI,
whereby any bank could challenge the need for any regulation or guideline and the department had to
justify the need and usefulness for such guideline relative to costs of regulation and compliance.
Fourth, to strengthen the banking system to cope up with the changing environment, prudential
standards have been imposed in a progressive manner. Thus, while banks have greater freedom to
take credit decisions, prudential norms setting out capital adequacy norms, asset classification,
income recognition and provisioning rules, exposure norms, and asset liability management systems
have helped to identify and contain risks, thereby contributing to greater financial stability.
Fifth, an appropriate legal, institutional, technological and regulatory framework has been put in place
for the development of financial markets. There is now increased volumes and transparency in the
primary and secondary market operations. Development of the Government Securities, money and
forex markets has improved the transmission mechanism of monetary policy, facilitated the
development of an yield curve and enabled greater integration of markets. The interest rate channel of
monetary policy transmission is acquiring greater importance as compared with the credit channel.
Regulatory environment
Prudential regulation and supervision have formed a critical component of the financial sector reform
programme since its inception, and India has endeavoured to international prudential norms and
practices. These norms have been progressively tightened over the years, particularly against the
backdrop of the Asian crisis. Bank exposures to sensitive sectors such as equity and real estate have
been curtailed. The Banking Regulation Act 1949 prevents connected lending (i.e. lending by banks to
directors or companies in which Directors are interested).
Periodical inspection of banks has been the main instrument of supervision, though recently there has
been a move toward supplementary 'on-site inspections' with 'off-site surveillance'. The system of
'Annual Financial Inspection' was introduced in 1992, in place of the earlier system of Annual Financial
Review/Financial Inspections. The inspection objectives and procedures, have been redefined to
evaluate the bank's safety and soundness; to appraise the quality of the Board and management; to
ensure compliance with banking laws & regulation; to provide an appraisal of soundness of the bank's
assets; to analyse the financial factors which determine bank's solvency and to identify areas where
corrective action is needed to strengthen the institution and improve its performance. Inspection based
upon the new guidelines have started since 1997.
A high powered Board for Financial Supervision (BFS), comprising the Governor of RBI as Chairman,
one of the Deputy Governors as Vice-Chairman and four Directors of the Central Board of RBI as
members was constituted in 1994, with the mandate to exercise the powers of supervision and
inspection in relation to the banking companies, financial institutions and non-banking companies.
A supervisory strategy comprising on-site inspection, off-site monitoring and control systems internal
to the banks, based on the CAMELS (capital adequacy, asset quality, management, earnings, liquidity
and systems and controls) methodology for banks have been instituted. The RBI has instituted a
mechanism for critical analysis of the balance sheet by the banks themselves and the presentation of
such analysis before their boards to provide an internal assessment of the health of the bank. The
analysis, which is also made available to the RBI, forms a supplement to the system of off-site
monitoring of banks.
Keeping in line with the merging regulatory and supervisory standards at international level, the RBI
has initiated certain macro level monitoring techniques to assess the true health of the supervised
institutions. The format of balance sheets of commercial banks have now been prescribed by the RBI
with disclosure standards on vital performance and growth indicators, provisions, net NPAs, staff
productivity, etc. appended as 'Notes of Accounts'. To bring about greater transparency in banks'
published accounts, the RBI has also directed the banks to disclose data on movement of
nonperforming assets (NPAs) and provisions as well as lending to sensitive sectors. These proposed
additional disclosure norms would bring the disclosure standards almost on par with the international
best practice.
Structural environment of banking
The nationalized banks are enabled to dilute their equity of Government of India to 51% following the
amendment to the Banking Companies (Acquisition & Transfer of Undertakings) Acts in 1994, bringing
down the minimum Government's shareholdings to 51 per cent in PSBs. RBI's shareholding in SBI is
subject to a minimum of 55 per cent. Ten banks have already raised capital from the market. The
Government proposed, in the Union Budget for the financial year 2000-01 to reduce its holding in
nationalised banks to a minimum of 33 per cent, while maintaining the public sector character of these
banks. The diversification of ownership of PSBs has made a qualitative difference to the functioning of
PSBs since there is induction of private shareholding and attendant issues of shareholder's value, as
reflected by the market cap, representation on board, and interests of minority shareholders. There is
representation of private shareholder when the banks raise capital from the market.
The governance of banks rests with the board of directors. In the light of deregulation in interest rates
and the greater autonomy given to banks in their operations, the role of the board of directors has
become more significant. During the years, Boards have been required to lay down policies in critical
areas such as investments, loans, asset-liability management, and management and recovery of
NPAs. As a part of this process, several Board level committees including the Management
Committee are required to be appointed by banks.
In 1995, the RBI directed banks to set up Audit Committees of their Boards, with the responsibility of
ensuring efficacy of the internal control and audit functions in the bank besides compliance with the
inspection report of the RBI, internal and concurrent auditors. To ensure both professionalism and
independence, the Chartered Accountant Directors on the boards of banks are mandatory members,
but the Chairman would not be part of the Audit Committee. Apart from the above, Board level
committees that are required to be set up are Risk Management committee, Asset Liability
Management committee (ALCO), etc. The Boards have also been given the freedom to constitute any
other committees, to render advice to it.
Government introduced a Bill in Parliament to omit the mandatory provisions regarding appointment of
RBI nominees on the Boards of public sector banks and instead to add a clause to enable RBI to
appoint its nominee on the boards of public sector banks if the RBI is of the opinion that in the interest
of the banking policy or in the public interest or in the interest of the bank or depositors, it is necessary
so to do.
As regards, appointment of Additional Directors on the Boards of private sector banks, since
December 1997, the RBI has been appointing such directors only in such of those 'banks making
losses for more than one year, having CRAR below 8%, NPAs exceeding 20% or where there are
disputes in the management.
Appointment of Chairman and Managing Directors and Executive Directors of all PSBs is done by
Government. The Narasimham Committee II had recommended that the appointment of Chairman and
Managing Director should be left to the Boards of banks and the Boards themselves should be elected
by shareholders. Government has set up an Appointment Board chaired by Governor, Reserve Bank
of India for these appointments. More recently, in case of appointment of Chief Executive Officer of the
PSBs identified as weak, the Government has formed a Search Committee with two outside experts.
Appointment as well as removal of auditors in PSBs require prior approval of the RBI. There is an
elaborate procedure by which banks select auditors from an approved panel circulated by the RBI. In
respect of private sector banks, the statutory auditors are appointed in the Annual General Meeting
with the prior approval by the RBI.
Self regulatory organizations
India has had the distinction of experimenting with Self Regulatory Organisations (SROs) in the
financial system since the pre-independence days. At present, there are four SROs in the financial
system - Indian Banks Association (IBA), Foreign Exchange Dealers Association of India (FEDAI),
Primary Dealers Association of India (PDAI) and Fixed Income Money Market Dealers Association of
India (FIMMDAI).
The IBA established in 1946 as a voluntary association of banks, strove towards strengthening the
banking industry through consensus and co-ordination. Since nationalisation of banks, PSBs tended to
dominate IBA and developed close links with Government and RBI. Often, the reactive and consensus
and coordinated approach bordered on cartelisation. To illustrate, IBA had worked out a schedule of
benchmark service charges for the services rendered by member banks, which were not mandatory in
nature, but were being adopted by all banks. The practice of fixing rates for services of banks was
consistent with a regime of administered interest rates but not consistent with the principle of
competition. Hence, the IBA was directed by the RBI to desist from working out a schedule of
benchmark service charges for the services rendered by member banks.
Responding to the imperatives caused by the changing scenario in the reform era, the IBA has, over
the years, refocused its vision, redefined its role, and modified its operational modalities.
In the area of foreign exchange, FEDAI was established in 1958, and banks were required to abide by
terms and conditions prescribed by FEDAI for transacting foreign exchange business. In the light of
reforms, FEDAI has refocused its role by giving up fixing of rates, but plays a multifarious role covering
training of banks' personnel, accounting standards, evolving risk measurement models like the VaR
and accrediting foreign exchange brokers.
In the financial markets, the two SROs, viz., the PDAI and the FIMMDAI are of recent origin i.e. 1996
and 1997. These two SROs have been proactive and are closely involved in contemporary issues
relating to development of money and government securities markets. The representatives of PDAI
and FIMMDAI are members of important committees of the RBI, both on policy and operational issues.
To illustrate, the Chairmen of PDAI and FIMMDAI are members of the Technical Advisory Group on
Money and Government Securities market of the RBI. These two SROs have been very proactive in
mounting the technological infrastructure in the money and Government Securities markets. The
FIMMDAI has now taken over the responsibility of publishing the yield curve in the debt markets.
Currently, the FIMMDAI is working towards development of uniform documentation and accounting
principles in the repo market.
Assessment of corporate governance in PSBs
A Standing Committee on International Financial Standards and Codes was constituted to, inter alia,
assess the status in India vis-à-vis the best global practices in regard to standards and codes. An
Advisory Group on Corporate Governance (Chairman: Dr. R. H. Patil) made detailed assessment and
gave recommendations of which those relating to PSBs is an important component. The Report
provides the most comprehensive set of recommendations on the subject, summarised in Box 1.
Box 1
Advisory Group on Corporate Governance
Currently in India, about four-fifths of the banking business is under the control of public

sector banks (PSBs), comprising the SBI and its subsidiaries and the nationalised banks.
Corporate governance in PSBs is complicated by the fact that effective management of
these banks vests with the government and the top managements and the boards of banks
operate merely as functionaries. The ground reality is such that the government performs
simultaneously multiple functions vis-à-vis the PSBs, such as the owner, manager,
quasiregulator, and sometimes even as the super-regulator. Unless the issues connected with
these multiple, and sometimes conflicting, functions are resolved and the boards of banks
are given the desired level of autonomy it would be difficult to improve the quality of
corporate governance in PSBs. One of the major factors that impinge directly on the quality
of corporate governance is the government ownership. It is desirable that all the banks are
brought under a single Act so that the corporate governance regimes do not have to be
different just because the entities are covered under multiple Acts of the Parliament or that
their ownership is in the private or public sector.
Even when the government dilutes its holdings to bring them significantly below the

threshold limit of 51 per cent, efforts to institute good governance practices would remain at
superficial level unless the government seriously redefines its role de novo. The changes
proposed in the composition of the boards as per legislation under contemplation would
result in government directly appointing 9 out of the 15 directors including the 4 whole time
directors. Moreover, the voting rights of any of the other shareholders will continue to be
restricted, thereby negating the basic principle of equal rights to all the shareholders. The
rights of private shareholders' of SBI/PSBs are abridged considerably, since their approval is
not required for paying dividend or adopting annual accounts. The subsidiaries of the SBI
enjoy very limited board autonomy as they have to get clearance on most of the important
matters from the parent even before putting them up to their boards. Further, as things stand
today, there is no equality among the various board members of the PSBs. Nominees of RBI
and Government are treated to be superior to other directors.
 Another major problem affecting banks has been the representation given to the various
interest groups on the boards of the banks. The main objective behind these representations
was to give voice to various sections of the society at the board level of the banks. Hence, a
major reform is needed in the area of constitution of the boards of the banks. The Chairmen,
Executive Directors and non-executive directors on the boards of the PSBs (including the
SBI and its subsidiaries) need to be appointed on the advice of an expert body set up on the
lines of the UPSC, with similar status and independence. Such a body may be set up jointly
by RBI and the Ministry of Finance. There is also no need to have directors that represent
narrow sectional and economic interests. All the objectives that the banks are supposed to
achieve should become an integral part of the corporate mission statements of these
institutions.
Although RBI maintains a tight vigil and inspects these entities thoroughly at regular time

intervals, the quality of corporate level governance mechanism does not appear to be
satisfactory. In its role as the regulator, RBI need not have representation on the bank
boards, given the fact that it leads to conflicts of interests with its regulatory functions. This
should apply even in the case of SBI where RBI is the major shareholder. Further, any policy
measures to protect banks that are less careful in their lending policies at the cost of tax
payers' money need to be tempered in such a way that they do not encourage profligate
lending by banks.
Current regulatory provisions do not permit a bank to lend money to a company if any of its

board members is also a director on the board of that company. The negative impact of this
rule has been that the banks are not able to get good professionals for their boards. This
archaic rule should be modified immediately so that the professionals who are on the boards
of non-banking companies as professional or independent directors do not suffer from any
handicaps. The current rule may, however, be continued only in respect of directors of
companies who are their promoters and have a stake in their companies beyond being
merely a director. In the interest of good governance, it is desirable that government
directors should not participate in the discussion on such matters and also abstain from
voting.
The Report of the Advisory Group on Banking Supervision (Chairman : Mr. M.S. Verma) has also
made some recommendations on corporate governance, which are summarised in Box 2.
Box 2
Advisory Group on Banking Supervision
The quality of corporate governance should be the same in all types of banking

organisations irrespective of their ownership. The process of induction of directors into
banks' boards and their initial orientation may be streamlined. Banks need to develop
mechanisms, which can help them ensure percolation of their strategic objectives and
corporate values throughout the organisation. Boards need to set and enforce clear lines of
responsibility and accountability for themselves as well as the senior management and
throughout the organisation. Linkage between contribution and remuneration/reward should
be established. Compensation Committees of the board could be set up for the purpose.
Nomination Committees to assess the effectiveness of the board and direct the process of
renewing and replacing board members are desirable. Disclosures in respect of committees
of the board and qualifications of the directors, incentive structure and the nature and extent
of transactions with affiliated and related parties need to be encouraged. Finally, a provision
on the lines of Section 20 of the Banking Regulation Act, 1949, which prohibits loans and
advances to directors and their connected parties, will have to be made in respect of large
shareholders also. Information on transactions with affiliated and related parties should be
disclosed.
Current proposal
It would be evident that the Reports of Advisory Groups contain far reaching proposals to improve
corporate governance and many, if not all, do require legislative processes and they are necessarily
time consuming and often realizable only in medium-term. While proceeding with analysis and
possible legislative actions, it may be necessary to consider and adopt changes that could be brought
about within the existing legislative framework.
To this end, Governor Jalan in his Monetary and Credit Policy Statement of October 2001 constituted
a Consultative Group of Directors of banks and financial institutions (Chairman Dr. A.S. Ganguly) to
review the supervisory role of Boards of banks and financial institutions and to obtain feedback on the
functioning of the Boards vis-à-vis compliance, transparency, disclosures, audit committees etc. and
make recommendations for making the role of Board of Directors more effective. The Group made its
recommendations very recently after a comprehensive review of the existing framework as well as of
current practices and benchmarked its recommendations with international best practices as
enunciated by the Basel Committee on Banking Supervision, as well as of other committees and
advisory bodies, to the extent applicable in the Indian environment. The report has been put in public
domain for a wider debate and its major recommendations are summarized in Box 3 :
Box 3
Report of the Consultative Group of Directors of Banks/Financial Institutions
 On appointment of Directors, due diligence of the directors of all banks - be they in public or
private sector, should be done in regard to their suitability for the post by way of
qualifications and technical expertise. Involvement of Nomination Committee of the Board in
such an exercise should be seriously considered as a formal process. Further, the
Government while nominating directors on the Boards of public sector banks should be
guided by certain broad "fit and proper" norms for the Directors. The criteria suggested by
the Bank for International Settlements (BIS) may be suitably adopted for considering "fit and
proper" test for bank directors.
In the present context of banking becoming more complex and knowledge-based, there is an

urgent need for making the Boards of banks more contemporarily professional by inducting
technical and specially qualified individual. While continuing regulation based representation
of sectors like agriculture, SSI, cooperation, etc., the appointment/nomination of
independent/ non-executive directors to the Board of banks (both public sector and private
sector) should be from a pool of professional and talented people to be prepared and
maintained by RBI. Any deviation from this procedure by any bank should be with the prior
approval of RBI.
On the functioning, the independent/non-executive directors should raise in the meetings of

the Board, critical questions relating to business strategy, important aspects of the
functioning of the bank and investor relations. In the case of private sector banks where
promoter directors may act in concert, the independent/non-executive directors should
provide effective checks and balances ensuring that the bank does not build up exposures to
entiti